AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

SUMMARY:

This document contains proposed regulations under section 1503(d) of
the Internal Revenue Code (Code) regarding dual consolidated losses. Section
1503(d) generally provides that a dual consolidated loss of a dual resident
corporation cannot reduce the taxable income of any other member of the affiliated
group unless, to the extent provided in regulations, such loss does not offset
the income of any foreign corporation. Similar rules apply to losses of separate
units of domestic corporations. The proposed regulations address various
dual consolidated loss issues, including exceptions to the general prohibition
against using a dual consolidated loss to reduce the taxable income of any
other member of the affiliated group.

DATES:

Written and electronic comments and outlines of topics to be discussed
at the public hearing scheduled for September 7, 2005, at 10:00 a.m., must
be received by August 22, 2005.

ADDRESSES:

Send submissions to CC:PA:LPD:PR (REG-102144-04), room 5203, Internal
Revenue Service, P.O. Box 7604, Washington, DC 20044. Submissions may be
hand delivered between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-102144-04),
Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue,
NW, Washington, DC, or sent electronically via the IRS Internet site at www.irs.gov/regs
or via the Federal eRulemaking Portal at www.regulations.gov/ (IRS
and REG-102144-04). The public hearing will be held in the Auditorium of the
Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT:

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking
has been submitted to the Office of Management and Budget in accordance with
the Paperwork Reduction Act of 1995 (44 USC 3507(d)). Comments on the collection
of information should be sent to the Office of Management
and Budget, Attn: Desk Officer for the Department of the Treasury,
Office of Information and Regulatory Affairs, Washington, DC 20503, with copies
to the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments
on the collection of information should be received by July 25, 2005. Comments
are specifically requested concerning:

Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the information
will have practical utility;

The accuracy of the estimated burden associated with the proposed collection
of information (see below);

How the quality, utility, and clarity of the information to be collected
may be enhanced;

How the burden of complying with the proposed collection of information
may be minimized, including through the application of automated collection
techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance,
and purchase of service to provide information.

The collections of information in these proposed regulations are in
§§1.1503(d)-1(b)(14), 1.1503(d)-1(c)(1), 1.1503(d)-2(d), 1.1503(d)-4(c)(2),
1.1503(d)-4(d), 1.1503(d)-4(e)(2), 1.1503(d)-4(f)(2), 1.1503(d)-4(g), 1.1503(d)-4(h)
and 1.1503(d)-4(i). The various information is required. First, it notifies
the IRS when the taxpayer asserts that it had reasonable cause for failing
to comply with certain filing requirements under the regulations. Second,
it indicates when the taxpayer attempts to rebut the amount of presumed tainted
income. Finally, it provides the IRS various information regarding exceptions
to the domestic use limitation, including domestic use elections, domestic
use agreements, triggering events and recapture.

The collection of information is in certain cases required and in certain
cases voluntary. The likely respondents will be domestic corporations with
foreign operations that generate losses.

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a valid control
number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained
as long as their contents may become material in the administration of any
internal revenue law. Generally, tax returns and tax return information are
confidential, as required by 26 USC 6103.

Background

The United States taxes the worldwide income of domestic corporations.
A domestic corporation is a corporation created or organized in the United
States or under the law of the United States or of any State. The United
States allows certain domestic corporations to file consolidated returns with
other affiliated domestic corporations. When two or more domestic corporations
file a consolidated return, losses that one corporation incurs generally may
reduce or eliminate tax on income that another corporation earns.

Some countries use criteria other than place of incorporation or organization
to determine whether corporations are residents for tax purposes. For example,
some countries treat corporations as residents for tax purposes if they are
managed or controlled in that country. If one of these countries determines
a corporation to be a resident, the corporation is generally subject to income
tax of that foreign country on a residence basis. As a result, if such a
corporation is a domestic corporation for U.S. tax purposes, it is a dual
resident corporation and is subject to the income tax of both the foreign
country and the United States on a residence basis.

Prior to the Tax Reform Act of 1986, if a corporation was a resident
of both a foreign country and the United States, and the foreign country permitted
the losses of the corporation to be used to offset the income of another person
(for example, as a result of consolidation), then the dual resident corporation
could use any losses it generated twice: once to offset income that was subject
to U.S. tax, but not foreign tax, and a second time to offset income subject
to foreign tax, but not U.S. tax (double-dip).

Congress was concerned that this double-dip of a single economic loss
could result in an undue tax advantage to certain foreign investors that made
investments in domestic corporations, and could create an undue incentive
for certain foreign corporations to acquire domestic corporations and for
domestic corporations to acquire foreign rather than domestic assets. Staff
of Joint Committee on Taxation, 99th Cong., 2nd Sess., General Explanation
of the Tax Reform Act of 1986, at 1064 - 1065 (1987). Through such double-dipping,
worldwide economic income could be rendered partially or fully exempt from
current taxation. Moreover, even if the foreign income against which the
loss was used would eventually be subject to U.S. tax (upon a repatriation
of earnings), there were timing benefits of double dipping that the statute
was intended to prevent. Congress responded to this concern by enacting section
1503(d) as part of the Tax Reform Act of 1986.

Section 1503(d) provides that a dual consolidated loss of a corporation
cannot reduce the taxable income of any other member of the corporation’s
affiliated group. The statute defines a dual consolidated loss as a net operating
loss of a domestic corporation that is subject to an income tax of a foreign
country on its income without regard to the source of its income, or is subject
to tax on a residence basis. The statute authorizes the issuance of regulations
permitting the use of a dual consolidated loss to offset the income of a domestic
affiliate if the loss does not offset the income of a foreign corporation
under foreign law.

Section 1503(d) further states that, to the extent provided in regulations,
similar rules apply to any loss of a separate unit of
a domestic corporation as if such unit where a wholly owned subsidiary of
the corporation. Although the statute does not define the term separate unit,
the legislative history to the provision refers to the loss of any separate
and clearly identifiable unit of a trade or business of a taxpayer and cites
as an example a foreign branch of a domestic corporation. See H.R. Rep. No.
795, 100th Cong., 2d Sess. July 26, 1988) at 293.

The IRS and Treasury issued temporary regulations under section 1503(d)
in 1989 (T.D. 8261, 1989-2 C.B. 220). The temporary regulations generally
provided that, unless one of three limited exceptions applied, a dual consolidated
loss of a dual resident corporation could not offset the income of any other
member of the dual resident corporation’s affiliated group. The temporary
regulations contained similar rules for losses incurred by separate units.

In response to comments that the temporary regulations were unnecessarily
restrictive, the IRS and Treasury issued final regulations under section 1503(d)
in 1992 (T.D. 8434, 1992-2 C.B. 240). These final regulations were updated
and amended over the next 11 years (current regulations). The current regulations
apply the section 1503(d) limitation more narrowly than the temporary regulations.
The current regulations adopt an actual use standard
for permitting a dual consolidated loss to offset income of members of the
affiliated group. This standard, which applies to both dual resident corporations
and separate units, requires taxpayers to certify that no portion of the dual
consolidated loss has been or will be used to offset the income of any other
person under the income tax laws of a foreign country. If such a certification
is made and a subsequent triggering event occurs, the
dual consolidated loss must be recaptured in the year of the event (plus an
applicable interest charge).

This document proposes amendments to the current regulations under section
1503(d). Conforming amendments are also proposed to related regulations under
sections 1502 and 6043.

Overview

In general, the proposed regulations address three fundamental concerns
that arise in connection with the current regulations. First, the IRS and
Treasury believe that the scope of application of the current regulations
should be modified. For example, the current regulations may apply to certain
structures where there is little likelihood of a double-dip. Moreover, the
IRS and Treasury understand that some taxpayers have taken the position that
the current regulations do not apply to certain structures that provide taxpayers
the benefits of the type of double-dip that section 1503(d) is intended to
deny. Accordingly, the proposed regulations are designed to minimize these
cases of potential over- and under-application.

Second, the IRS and Treasury recognize that there are many unresolved
issues that arise when applying the current regulations, particularly in light
of the adoption of the entity classification regulations under §§301.7701-1
through 301.7701-3. Thus, the proposed regulations modernize the dual consolidated
loss regime to take into account the entity classification regulations and
to resolve the related issues so that the rules can be applied by taxpayers
and the Commissioner with greater certainty.

Finally, the IRS and Treasury believe that, in many cases, the current
regulations are administratively burdensome to both taxpayers and the Commissioner.
Accordingly, the proposed regulations reduce, to the extent possible, the
administrative burden imposed on taxpayers and the Commissioner.

Explanation of Provisions

A. Structure of the Proposed Regulations

The proposed regulations are set forth in six sections. Section 1.1503(d)-1
contains definitions and special rules for filings. Section 1.1503(d)-2 sets
forth operating rules, which include the general rule that prohibits the domestic
use of a dual consolidated loss (subject to certain exceptions discussed below),
a rule that limits the use of dual consolidated losses following certain transactions,
an anti-avoidance provision that prevents dual consolidated losses from offsetting
income from assets acquired in certain nonrecognition transactions or contributions
to capital, and rules for computing foreign tax credit limitations. Section
1.1503(d)-3 contains special rules for accounting for dual consolidated losses.
These special rules determine the amount of a dual consolidated loss, determine
the effect of a dual consolidated loss on domestic affiliates, and provide
special basis adjustments. Section 1.1503(d)-4 provides exceptions to the
general rule that prohibits the domestic use of a dual consolidated loss,
including a domestic use election. Section 1.1503(d)-5 contains examples
that illustrate the application of the proposed regulations. Finally, §1.1503(d)-6
contains the proposed effective date of the proposed regulations.

In addition to the proposed regulatory amendments under section 1503(d),
the proposed regulations also include conforming proposed amendments to §1.1502-21
and §1.6043-4T.

B. Definitions and Special Rules for Filings under Section
1503(d) — §1.1503(d)-1

1. Treatment of a separate unit as a domestic corporation
and a dual resident corporation

Section 1.1503-2(c)(3) and (4) of the current regulations defines a
separate unit of a domestic corporation as a foreign branch, within the meaning
of §1.367(a)-6T(g), (foreign branch separate unit) and an interest in
a partnership, trust or hybrid entity. The current regulations also provide
that any separate unit of a domestic corporation is treated as a separate
domestic corporation for purposes of applying the dual consolidated loss rules.
Section 1.1503-2(c)(2). In addition, the current regulations provide that,
unless otherwise indicated, any reference to a dual resident corporation refers
also to a separate unit. As a result of these rules, certain provisions of
the current regulations only refer to dual resident corporations, and therefore
apply to separate units because they are treated as domestic corporations
and dual resident corporations. However, other provisions of the current
regulations refer to both dual resident corporations and separate units (for
example, see §1.1503-2(g)(2)(iii)(A)).

The IRS and Treasury believe that, in certain cases, treating separate
units as domestic corporations creates uncertainty in applying the current
regulations. This may occur, for example, as a result of certain rules applying
to separate units because they are treated as domestic corporations or dual
resident corporations, while other rules apply explicitly to separate units
themselves. Accordingly, the proposed regulations do not contain a general
rule that treats separate units as domestic corporations or dual resident
corporations for all purposes of applying the dual consolidated loss regulations.
Instead, the proposed regulations explicitly refer to dual resident corporations
and separate units where appropriate, treat separate units as domestic corporations
only for limited purposes, and modify the operative rules where necessary
to take into account differences between dual resident corporations and separate
units.

2. Application of section 1503(d) to S corporations

Section 1.1503-2(c)(2) of the current regulations provides that an S
corporation, as defined in section 1361, is not a dual resident corporation.
The preamble to the current regulations explains that S corporations are
so excluded because an S corporation cannot have a domestic corporation as
one of its shareholders. The current regulations do not, however, explicitly
exclude separate units owned by an S corporation from the definition of a
dual resident corporation. As a result, the current regulations can be read
to provide that an S corporation, although it cannot itself be a dual resident
corporation, could own a separate unit that would be a dual resident corporation.

The IRS and Treasury believe that such a result is inappropriate because
an S corporation cannot have a domestic corporation as one of its shareholders
and generally is not taxable at the entity level. Accordingly, the proposed
regulations provide that for purposes of the dual consolidated loss rules,
an S corporation is not treated as a domestic corporation. This modification
clarifies that the dual consolidated loss regulations do not apply to the
S corporation itself, or to foreign branches or interests in certain flow-through
entities owned by an S corporation.

The IRS and Treasury request comments as to whether regulated investment
companies (as defined in section 851) or real estate investment trusts (as
defined in section 856) should be similarly excluded from the application
of the dual consolidated loss rules.

3. Losses of a foreign insurance company treated as a domestic
corporation

Section 953(d) generally provides that a foreign corporation that would
qualify to be taxed as an insurance company if it were a domestic corporation
may, under certain circumstances, elect to be treated as a domestic corporation.
Section 953(d)(3) provides that if a corporation elects to be treated as
a domestic corporation pursuant to section 953(d) and is treated as a member
of an affiliated group, any loss of such corporation is treated as a dual
consolidated loss for purposes of section 1503(d), without regard to section
1503(d)(2)(B) (grant of regulatory authority to exclude losses which do not
offset the income of foreign corporations from the definition of a dual consolidated
loss). Therefore, losses of such corporations are treated as dual consolidated
losses regardless of whether the corporation is subject to an income tax of
a foreign country on its worldwide income or on a residence basis.

The current regulations do not address the application of section 953(d)(3).
However, the definition of a dual resident corporation contained in the proposed
regulations includes a foreign insurance company that makes an election to
be treated as a domestic corporation pursuant to section 953(d) and is a member
of an affiliated group, regardless of how such entity is taxed by the foreign
country.

4. Definition of a separate unit

Section 1.1503-2(c)(4) of the current regulations defines a separate
unit to include an interest in a hybrid entity (hybrid entity separate unit).
The current regulations define a hybrid entity as an entity that is not taxable
as an association for U.S. income tax purposes, but is subject to income tax
in a foreign jurisdiction as a corporation (or otherwise at the entity level)
either on its worldwide income or on a residence basis. This definition includes
an interest in such an entity that is treated for U.S. tax purposes as a partnership
(hybrid entity partnership) or as a grantor trust (hybrid entity grantor trust).
An interest in an entity that is treated as a partnership or a grantor trust
for both U.S. and foreign tax purposes (non-hybrid entity partnership and
non-hybrid entity grantor trust, respectively) also is treated as a separate
unit under the current regulations. §1.1503-2(c)(3)(i).

The current regulations also apply to a separate unit owned indirectly
through a partnership or grantor trust. Thus, for example, if a partnership
owns a foreign branch within the meaning of §1.367(a)-6T(g), a domestic
corporate partner’s interest in such partnership, and its indirect interest
in a portion of the foreign branch owned through the partnership, each constitutes
a separate unit.

Under the current regulations, an interest in a non-hybrid entity partnership
or a non-hybrid entity grantor trust is also treated as a separate unit, regardless
of whether the partnership or grantor trust has any nexus with a foreign jurisdiction.
This rule can result in the application of the dual consolidated loss rules
when there may be little opportunity for a double-dip. For example, if two
domestic corporations each own 50 percent of a domestic partnership that generates
losses attributable to activities conducted solely in the United States, the
corporate partners would be technically subject to the dual consolidated loss
rules and therefore would not be allowed to offset their income with such
losses, unless an exception applied. In such a case, however, it may be unlikely
that the losses would be available to offset income of another person under
the income tax laws of a foreign country.

The IRS and Treasury believe that including an interest in a non-hybrid
entity partnership and an interest in a non-hybrid entity grantor trust in
the definition of a separate unit may not be necessary and is administratively
burdensome. In such cases, it may be unlikely that deductions and losses
solely attributable to activities of the partnership or grantor trust, that
do not rise to the level of a taxable presence in a foreign jurisdiction,
can be used to offset income of another person under the income tax laws of
a foreign country. As a result, the proposed regulations eliminate from the
definition of a separate unit an interest in a non-hybrid entity partnership
and an interest in a non-hybrid entity grantor trust. It should be noted,
however, that the proposed regulations retain the rule contained in the current
regulations that a domestic corporation can own a separate unit indirectly
through both hybrid entity and non-hybrid entity partnerships, and through
both hybrid entity and non-hybrid entity grantor trusts.

(b) Separate Unit Combination Rule

Section 1.1503-2(c)(3)(ii) of the current regulations provides that
if two or more foreign branches located in the same foreign country are owned
by a single domestic corporation and the losses of each branch are made available
to offset the income of the other branches under the tax laws of the foreign
country, then the branches are treated as one separate unit. The combination
rule in the current regulations does not apply to interests in hybrid entity
separate units or to dual resident corporations.

Although a disregarded entity is treated as a branch of its owner for
various purposes of the Code, the current regulations distinguish a hybrid
entity separate unit that is disregarded as an entity separate from its owner
from a foreign branch separate unit. Compare §1.1503-2(c)(3)(i)(A) and
(c)(4); see also §1.1503-2(g)(2)(vi)(C). Accordingly, the combination
rule under the current regulations does not apply to an interest in a hybrid
entity separate unit, even if the hybrid entity is disregarded as an entity
separate from its owner.

The combination rule in the current regulations also requires the foreign
branches to be owned by a single domestic corporation. Thus, for example,
the current regulations do not permit the combination of foreign branches
owned by different domestic corporations, even if such corporations are members
of the same consolidated group. In addition, in some cases the current regulations
do not allow the combination of foreign branches that are owned indirectly
by a single domestic corporation through other separate units because, as
discussed above, such other separate units are generally treated as domestic
corporations for purposes of applying the dual consolidated loss regulations.
As a result, such foreign branches are not treated as being owned by a single
domestic corporation.

The IRS and Treasury believe that the application of the combination
rule should not be restricted to foreign branch separate units. In addition,
the IRS and Treasury believe that the combination rule should not be limited
to those cases where the domestic corporation owns the separate units directly.
Therefore, provided certain requirements are satisfied, the proposed regulations
adopt a broader combination rule that combines all separate units that are
directly or indirectly owned by a single domestic corporation.

In order for separate units to be combined under the proposed regulations,
the losses of each separate unit must be made available to offset the income
of the other separate units under the tax laws of a single foreign country.
In addition, if the separate unit is a foreign branch separate unit, it must
be located in the foreign country that allows its losses to be made available
to offset income of each separate unit; if the separate unit is a hybrid entity
separate unit, the hybrid entity must be subject to tax in the foreign country
that allows losses to be made available to each separate unit either on its
worldwide income or on a residence basis.

The combination rule in the proposed regulations does not combine separate
units owned by different domestic corporations, even if the domestic corporations
are included in the same consolidated group. The IRS and Treasury believe
this approach is consistent with section 1503(d)(3), which provides that,
to the extent provided in regulations, a loss of a separate unit of a domestic
corporation is subject to the dual consolidated loss rules as if it were a
wholly owned subsidiary of such domestic corporation. In addition, the combination
rule contained in the proposed regulations only applies to separate units
and therefore does not apply to dual resident corporations.

The IRS and Treasury, however, request comments as to whether there
is authority to expand the combination rule and, if so, whether the combination
rule should be expanded to include separate units that are owned directly
or indirectly by domestic corporations that are members of the same consolidated
group. Similarly, comments are requested as to whether the combination rule
should be extended to apply to dual resident corporations. Further, the IRS
and Treasury request comments on the application of the operative provisions
of the proposed regulations to combined separate units owned by different
domestic corporations (for example, the SRLY limitation under §1.1503(d)-3(c)).

5. Exception to the definition of a dual consolidated loss

Section 1.1503-2(c)(5)(ii)(A) of the current regulations provides a
very limited exception to the definition of a dual consolidated loss where
the income tax laws of a foreign country do not permit the dual resident corporation
to either: (1) use its losses, expenses, or deductions to offset the income
of any other person in the same taxable year; or (2) carry over or carry back
its losses, expenses, or deductions to be used, by any means, to offset the
income of any other person in other taxable years. This exception only applies
in rare and unusual cases where the income tax laws of the foreign country
do not allow any portion of the dual consolidated loss to be used to offset
income of another person under any circumstances.

The IRS and Treasury understand that some taxpayers have improperly
interpreted this provision in a manner inconsistent with the policies of the
dual consolidated loss rules. As a result, the proposed regulations eliminate
this exception to the definition of a dual consolidated loss. As discussed
below, however, the proposed regulations contain a new exception to the general
rule restricting the use of a dual consolidated loss to offset income of a
domestic affiliate. In general, this new exception applies when there is
no possibility that any portion of the dual consolidated loss can be double-dipped,
and operates in a manner that is similar to the manner in which the exception
to the definition of a dual consolidated loss contained in the current regulations
operates.

6. Partnership special allocations

Section 1.1503-2(c)(5)(iii) of the current regulations reserves on the
treatment of dual consolidated losses of separate units that are partnership
interests, including interests in hybrid entities. The preamble to the current
regulations explains that the reservation was principally the result of concerns
regarding partnership special allocations.

The proposed regulations no longer reserve on the treatment of separate
units that are partnership interests. However, the IRS will continue to challenge
structures that attempt to use special allocations in a manner that is inconsistent
with the principles of section 1503(d).

7. Domestic use of a dual consolidated loss

Section 1.1503-2(b)(1) of the current regulations states that, except
as otherwise provided, a dual consolidated loss cannot offset the taxable
income of any domestic affiliate, regardless of whether the loss offsets income
of another person under the income tax laws of a foreign country, and regardless
of whether the income that the loss may offset in the foreign country is,
has been, or will be subject to tax in the United States. Section 1.1503-2(c)(13)
defines the term domestic affiliate to mean any member of an affiliated group,
without regard to exceptions contained in section 1504(b) (other than section
1504(b)(3)) relating to includible corporations.

The proposed regulations retain the general prohibition against using
a dual consolidated loss to offset income of domestic affiliates contained
in the current regulations, with modifications, and refer to such usage as
a domestic use of a dual consolidated loss. This general
prohibition is subject to a number of exceptions, discussed below. In addition,
because the proposed regulations do not treat separate units as domestic corporations
and dual resident corporations (other than for limited purposes) the proposed
regulations expand the definition of a domestic affiliate to include separate
units. This expanded definition is necessary for purposes of applying the
domestic use limitation rule.

8. Foreign use of a dual consolidated loss

(a) General Rule

Section 1.1503-2T(g)(2)(i) of the current regulations provides that,
in order to elect relief from the general limitation on the use of a dual
consolidated loss to offset income of a domestic affiliate with respect to
a dual consolidated loss ((g)(2)(i) election), the taxpayer must, among other
things, certify that no portion of the losses, expenses, or deductions taken
into account in computing the dual consolidated loss has been, or will be,
used to offset the income of any other person under the income tax laws of
a foreign country. If, contrary to this certification, there is such a use,
the dual consolidated loss subject to the (g)(2)(i) election generally must
be recaptured and reported as gross income.

The IRS and Treasury understand that issues arise involving the application
of the use rule contained in the current regulations. For example, issues
may arise where items of income, gain, deduction and loss are treated as being
generated or incurred by different persons under U.S. and foreign law. Similarly,
issues may arise due to different definitions of a person under
U.S. and foreign law. These issues have become more prevalent since the adoption
of the entity classification regulations under §§301.7701-1 through
301.7701-3.

The IRS and Treasury also understand that taxpayers have taken positions
under the current regulations regarding the use of a dual consolidated loss
that are inconsistent with the policies underlying section 1503(d). On the
other hand, the IRS and Treasury believe that, under the current regulations,
a use can be deemed to occur in certain cases where there may be little likelihood
of the type of double-dip that section 1503(d) was intended to prevent.

For the reasons discussed above, the proposed regulations modify the
definition of use and provide a rule based on foreign
use. These modifications are intended to minimize the potential
over- and under-application of the dual consolidated loss rules that can occur
under the current regulations. Under the proposed regulations, the foreign
use definition is intended to minimize the opportunity for a double-dip.
However, the new definition is also intended to minimize the situations in
which a foreign use will occur in cases where there may be little likelihood
of a double-dip.

The proposed regulations provide that a foreign use is deemed to occur
only if two conditions are satisfied. The first condition is satisfied if
any portion of a loss or deduction taken into account in computing the dual
consolidated loss is made available under the income tax laws of a foreign
country to offset or reduce, directly or indirectly, any item that is recognized
as income or gain under such laws (including items of income or gain generated
by the dual resident corporation or separate unit itself), regardless of whether
income or gain is actually offset, and regardless of whether such items are
recognized under U.S. tax principles. This condition ensures that there will
not be a foreign use unless all or a portion of the dual consolidated loss
offsets or reduces, or is made available to offset or reduce, income or gain
for foreign tax purposes.

The second condition is satisfied if items that are (or could be) offset
pursuant to the first condition are considered, under U.S. tax principles,
to be items of: (1) a foreign corporation; or (2) a direct or indirect (for
example, through a partnership) owner of an interest in a hybrid entity, provided
such interest is not a separate unit. This condition is intended to limit
a foreign use to situations where the foreign income that is (or could be)
offset by the dual consolidated loss is not currently subject to U.S. corporate
income tax. In general, if the foreign income that is offset is currently
subject to U.S. corporate income tax, there is no double-dip of the dual consolidated
loss.

(b) Exception to Foreign Use if no Dilution of an Interest
in a Separate Unit

Section 1.1503-2(c)(15) of the current regulations employs a so-called actual
use standard for determining whether there has been a use of a
dual consolidated loss to offset the income of another person under the laws
of a foreign country. Although referred to as an actual use standard,
this rule provides that a use is considered to occur in the year in which
a loss, expense or deduction taken into account in computing the dual consolidated
loss is made available for such an offset, unless an exception applies. The
fact that the other person does not have sufficient income in that year to
benefit from such an offset is not taken into account.

The available component of the actual use standard
was adopted because of the administrative complexity that would result from
having a use occur only when income is actually offset. For example, if in
the year that a portion of the dual consolidated loss is made available to
be used by another person, the other person itself generates a loss (or has
a loss carryover), then in many cases the portion of the dual consolidated
loss would become part of the loss carryover. Such loss therefore would be
available to be carried forward or carried back to offset income in different
taxable years. Under this approach, the portion of the loss carryforward
or carryback that was taken into account in computing the dual consolidated
loss would need to be identified and tracked, which would require detailed
ordering rules for determining when such losses were used. Timing and base
differences between the U.S. and foreign jurisdiction would further complicate
such an approach.

Because of the administrative complexities discussed above, the foreign
use definition contained in the proposed regulations retains the available
for use standard. However, because the available for use standard is retained,
there are many cases in which a foreign use of a dual consolidated loss attributable
to interests in hybrid entity partnerships and hybrid entity grantor trusts,
and separate units owned indirectly through partnerships and grantor trusts,
occurs, even though no portion of any item of deduction or loss comprising
the dual consolidated loss is double-dipped. In the case of interests in
hybrid entity partnerships and hybrid entity grantor trusts, a portion of
the dual consolidated loss attributable to an interest in such entity in many
cases would be made available to offset income or gain of a direct or indirect
owner of an interest in such hybrid entity, provided such interest is not
a separate unit. This typically would occur because under foreign law the
hybrid entity is taxed as a corporation (or otherwise at the entity level)
and its net losses may be carried forward or carried back. A similar result
may occur in the case of a separate unit owned indirectly through a non-hybrid
entity partnership or a non-hybrid entity grantor trust because of timing
and base differences between the laws of the United States and the foreign
jurisdiction.

The IRS and Treasury believe this is an inappropriate result in many
cases. For example, the IRS and Treasury believe that if there is no dilution
of the domestic owner’s interest in the separate unit, it is unlikely
that any portion of the dual consolidated loss attributable to such separate
unit can be put to a foreign use (other than through an election to consolidate
or similar method, discussed below). Therefore, the proposed regulations
include three new exceptions to the definition of a foreign use where there
is no dilution of an interest in a separate unit. The new exceptions to foreign
use apply to dual consolidated losses attributable to two types of separate
units: (1) interests in hybrid entity partnerships and interests in hybrid
entity grantor trusts; and (2) separate units owned indirectly through partnerships
and grantor trusts.

The first exception to foreign use provides that, in general, no foreign
use shall be considered to occur with respect to a dual consolidated loss
attributable to an interest in a hybrid entity partnership or a hybrid entity
grantor trust, solely because an item of deduction or loss taken into account
in computing such dual consolidated loss is made available, under the income
tax laws of a foreign country, to offset or reduce, directly or indirectly,
any item that is recognized as income or gain under such laws and is considered
under U.S. tax principles to be an item of the direct or indirect owner of
an interest in such hybrid entity that is not a separate unit.

The second exception to foreign use provides that, in general, no foreign
use shall be considered to occur with respect to a dual consolidated loss
attributable to or taken into account by a separate unit owned indirectly
through a partnership or grantor trust solely because an item of deduction
or loss taken into account in computing such dual consolidated loss is made
available, under the income tax laws of a foreign country, to offset or reduce,
directly or indirectly, any item that is recognized as income or gain under
such laws and is considered under U.S. tax principles to be an item of a direct
or indirect owner of an interest in such partnership or trust.

Finally, the proposed regulations provide a similar exception for combined
separate units that include individual separate units to which one of the
other dilution exceptions would apply, but for the separate unit combination
rule.

The new exceptions to foreign use are subject to certain limitations,
however. First, the exceptions will not apply if there has been a dilution
of the interest in the separate unit. That is, the exception will not apply
if during any taxable year the domestic owner’s percentage interest
in the separate unit, as compared to its interest in the separate unit as
of the last day of the taxable year in which such dual consolidated loss was
incurred, is reduced as a result of another person acquiring through sale,
exchange, contribution or other means an interest in such partnership or grantor
trust, unless the taxpayer demonstrates, to the satisfaction of the Commissioner,
that the other person that acquired the interest in the partnership or grantor
trust was a domestic corporation. The exceptions to foreign use should not
apply when a person (other than a domestic corporation) acquires an interest
in the separate unit because the dilution would typically result in an actual
foreign use.

Second, the exceptions do not apply if the availability does not arise
solely from the ownership in such partnership or trust and the allocation
of the item of deduction or loss, or the offsetting by such deduction or loss,
of an item of income or gain of the partnership or trust. For example, the
exception does not apply in the case where the item of loss or deduction is
made available through a foreign consolidation regime.

The IRS and Treasury request comments on the issues discussed above
in connection with the availability component of the foreign use definition.
Comments are specifically requested as to whether the dilution rules are
appropriate and, if so, whether a de minimis exception
should be provided.

9. Mirror legislation rule

Section 1.1503-2(c)(15)(iv) of the current regulations contains a mirror
legislation rule that addresses legislation enacted by foreign
jurisdictions that operates in a manner similar to the dual consolidated loss
rules. This rule was designed to prevent the revenue gain resulting from
the disallowance of the double-dip benefit of a dual consolidated loss from
inuring solely to the foreign jurisdiction (to the detriment of the United
States). Staff of the Joint Committee on Taxation, General Explanation of
the Tax Reform Act of 1986, at 1065-66 (J. Comm. Print 1987).

Congress recognized that mirror legislation in a foreign jurisdiction,
in conjunction with a mirror legislation rule such as that contained in the
current regulations, could result in the disallowance of a dual consolidated
loss in both the United States and in the foreign jurisdiction. In such a
case, Congress intended that Treasury pursue with the appropriate authorities
in the foreign jurisdiction a bilateral agreement that would allow the use
of the loss of a dual resident corporation to offset income of an affiliate
in only one country. Staff of the Joint Committee on Taxation, General Explanation
of the Tax Reform Act of 1986, at 1066. The mirror rule was specifically
held to be valid by the Court of Appeals for the Federal Circuit. British
Car Auctions, Inc. v. United States, 35 Fed. Cl. 123 (1996), aff’d
without op., 116 F.3d 1497 (Fed. Cir. 1997).

The mirror legislation rule contained in the current regulations provides
that if the laws of a foreign country deny the use of a loss of a dual resident
corporation (or separate unit) to offset the income of another person because
the dual resident corporation (or separate unit) is also subject to tax by
another country on its worldwide income or on a residence basis, the loss
is deemed to be used against the income of another person in such foreign
country such that no (g)(2)(i) election can be made with respect to such loss.
This rule is intended to prevent the foreign jurisdiction from enacting legislation
that gives taxpayers no choice but to use the dual consolidated loss to offset
income in the United States. This result is contrary to the general policy
underlying the structure of the current regulations that provides taxpayers
the choice of using the dual consolidated loss to either offset income in
the United States or income in the foreign jurisdiction (but not both).

As a result of the consistency rule (discussed below), the deemed use
of a dual consolidated loss pursuant to the mirror legislation rule may also
restrict the ability to use other dual consolidated losses to offset the income
of domestic affiliates, even if such losses are not subject to the mirror
legislation.

Subsequent to the issuance of the current regulations, several foreign
jurisdictions enacted various forms of mirror legislation that, absent the
mirror legislation rule, would have the effect of forcing certain taxpayers
to use dual consolidated losses to offset income of domestic affiliates.

Given the relevant legislative history and British Car Auctions,
the IRS and Treasury believe that the mirror legislation rule remains necessary.
This is particularly true in light of the prevalence of mirror legislation
in foreign jurisdictions. As a result, the proposed regulations retain the
mirror legislation rule. The proposed regulations modify the mirror legislation
rule, however, to address its proper application with respect to mirror legislation
enacted subsequent to the issuance of the current regulations, and to modify
its application to better take into account the policies underlying the consistency
rule.

In general, the mirror legislation rule contained in the proposed regulations
applies when the opportunity for a foreign use is denied because: (1) the
loss is incurred by a dual resident corporation that is subject to income
taxation by another country on its worldwide income or on a residence basis;
(2) the loss may be available to offset income other than income of the dual
resident corporation or separate unit under the laws of another country; or
(3) the deductibility of any portion of a loss or deduction taken into account
in computing the dual consolidated loss depends on whether such amount is
deductible under the laws of another country.

The IRS and Treasury understand that there may be uncertainty as to
the application of the mirror legislation rule in a given case when the mirror
legislation is limited in its application. Mirror legislation may or may
not apply to a particular dual resident corporation or separate unit depending
on various factors, including the type of entity or structure that generates
the loss, the ownership of the operation or entity that generates the loss,
the manner in which the operation or entity is taxed in another jurisdiction,
or the ability of the losses to be deducted in another jurisdiction. As a
result, the proposed regulations clarify that the mere existence of mirror
legislation, regardless of whether it applies to the particular dual resident
corporation, may not result in a deemed foreign use. For example, see §1.1503(d)-5(c) Example
23.

The proposed regulations also clarify that the absence of an affiliate
in the foreign jurisdiction, or the failure to make an election to enable
a foreign use, does not prevent the opportunity for a foreign use. Thus,
for example, the mirror legislation rule may apply even if there are no affiliates
of the dual resident corporation in the foreign jurisdiction or, even where
there is such an affiliate, no election is made to consolidate.

As discussed below, the consistency rule is intended to promote uniformity
and reduce administrative burdens. The IRS and Treasury believe that these
concerns may not be significant, however, where there is only a deemed foreign
use of a dual consolidated loss as a result of the mirror legislation rule.
Accordingly, the mirror legislation rule contained in the proposed regulations
provides that a deemed foreign use is not treated as a foreign use for purposes
of applying the consistency rule.

10. Reasonable cause exception

The current regulations require various filings to be included on a
timely filed tax return. In addition, taxpayers that fail to include such
filings on a timely filed tax return must request an extension of time to
file under §301.9100-3.

The IRS and Treasury believe that requiring taxpayers to request relief
for an extension of time to file under §301.9100-3 results in an unnecessary
administrative burden on both taxpayers and the Commissioner. The IRS and
Treasury believe that a reasonable cause standard, similar to that used in
other international provisions of the Code (such as sections 367(a) and 6038B),
is a more appropriate and less burdensome means for taxpayers to cure compliance
defects under section 1503(d). As a result, the proposed regulations adopt
a reasonable cause standard. Moreover, extensions of time under §301.9100-3
will not be granted for filings under these proposed regulations. See §301.9100-1(d).

Under the reasonable cause standard, if a person that is permitted or
required to file an election, agreement, statement, rebuttal, computation,
or other information under the regulations fails to make such a filing in
a timely manner, such person shall be considered to have satisfied the timeliness
requirement with respect to such filing if the person is able to demonstrate,
to the satisfaction of the Director of Field Operations having jurisdiction
of the taxpayer’s tax return for the taxable year, that such failure
was due to reasonable cause and not willful neglect. Once the person becomes
aware of the failure, the person must make this demonstration and comply by
attaching all the necessary filings to an amended tax return (that amends
the tax return to which the filings should have been attached), and including
a written statement explaining the reasons for the failure to comply.

In determining whether the taxpayer has reasonable cause, the Director
of Field Operations shall consider whether the taxpayer acted reasonably and
in good faith. Whether the taxpayer acted reasonably and in good faith will
be determined after considering all the facts and circumstances. The Director
of Field Operations shall notify the person in writing within 120 days of
the filing if it is determined that the failure to comply was not due to reasonable
cause, or if additional time will be needed to make such determination.

C. Operating Rules — §1.1503(d)-2

1. Application of rules to multiple tiers of separate units

Section 1.1503-2(b)(3) of the current regulations provides that if a
separate unit of a domestic corporation is owned indirectly through another
separate unit, limitations on the dual consolidated losses of the separate
units apply as if the upper-tier separate unit were a subsidiary of the domestic
corporation, and the lower-tier separate unit were a lower-tier subsidiary.
In light of changes made to other provisions of the proposed regulations,
this rule is no longer necessary. As a result, the proposed regulations do
not contain this provision.

2. Tainted income

Section 1.1503-2(e) of the current regulations prevents the dual consolidated
loss of a dual resident corporation that ceases being a dual resident corporation
from offsetting tainted income of such corporation. Subject to certain exceptions,
tainted income is defined as income derived from assets that are acquired
by a dual resident corporation in a nonrecognition transaction, or as a contribution
to capital, at any time during the three taxable years immediately preceding
the tax year in which the corporation ceases to be a dual resident corporation,
or at any time thereafter. The current regulations also contain a rule that,
absent proof to the contrary, presumes an amount of income generated during
a taxable year as being tainted income. Such amount is the corporation’s
taxable income for the year multiplied by a fraction, the numerator of which
is the fair market value of the tainted assets at the end of the year, and
the denominator of which is the fair market value of the total assets owned
by each domestic corporation at the end of each year.

The tainted income rule is intended to prevent taxpayers from obtaining
a double-dip with respect to a dual consolidated loss by stuffing assets into
a dual resident corporation after, or in certain cases before, it terminates
its status as a dual resident corporation. A double-dip may be obtained in
such case because the income that offsets the dual consolidated loss generally
would not be subject to tax in the foreign jurisdiction after the dual resident
status of the corporation terminates.

The proposed regulations retain the tainted income rule, subject to
the following modifications. The proposed regulations clarify that tainted
income includes both income or gain recognized on the sale or other disposition
of tainted assets and income derived as a result of holding tainted assets.
The proposed regulations also modify the rule defining the amount of income
presumed to be tainted income. The proposed regulations clarify that the
presumptive rule only applies to income derived as a result of holding tainted
assets; income or gain recognized on the sale or other disposition of tainted
assets should be readily determinable such that the presumptive rule need
not apply. The proposed regulations also provide that the numerator in the
presumptive income fraction is the fair market value of tainted assets determined
at the time such assets were acquired by the corporation, as opposed to being
determined at the end of the taxable year. The IRS and Treasury believe that
this approach is more administrable because value should be more readily determinable
on the acquisition date. In addition, this approach does not require tainted
assets to be traced over time.

1. Items attributable to a separate unit

(a) Overview

Section 1.1503-2(d)(1)(ii) of the current regulations provides a rule
for determining whether a separate unit has a dual consolidated loss. Under
this rule, the separate unit must compute its taxable income as if it were
a separate domestic corporation that is a dual resident corporation, using
only those items of income, expense, deduction, and loss that are otherwise
attributable to such separate unit.

The current regulations do not provide any guidance for determining
the items of income, gain, deduction and loss that are otherwise attributable
to a separate unit. The IRS and Treasury understand that the absence of such
guidance has resulted in considerable uncertainty. For example, commentators
have questioned whether all or any portion of the interest expense of a domestic
owner is attributable to a separate unit.

It is also unclear the extent to which a separate unit is treated as
a separate domestic corporation under this rule. For example, commentators
have questioned whether a transaction between a separate unit and its owner
that is generally disregarded for federal tax purposes (for example, interest
paid by a disregarded entity on an obligation held by its owner) can create
an item of income, gain, deduction or loss for purposes of calculating a dual
consolidated loss.

Commentators have also questioned whether each separate unit in a tiered
separate unit structure (that is, where one separate unit owns another separate
unit) must separately determine whether it has a dual consolidated loss, or
whether such separate units are combined for this purpose.

The proposed regulations provide more definitive rules for determining
the amount of a dual consolidated loss (or income) of a separate unit. These
rules apply solely for purposes of section 1503(d) and, therefore, do not
apply for other purposes of the Code (for example, section 987). The proposed
regulations first provide general rules that apply for purposes of calculating
dual consolidated losses (or income) for both foreign branch separate units
and hybrid entity separate units. The proposed regulations provide additional
rules for calculating the dual consolidated losses (or income) of foreign
branch separate units, hybrid entity separate units, and separate units owned
indirectly through other separate units, non-hybrid entity partnerships, or
non-hybrid entity grantor trusts. Finally, the proposed regulations provide
special rules that apply to tiered separate units, combined separate units,
dispositions of separate units, and the treatment of certain income inclusions
on stock.

(b) General Rules

The proposed regulations clarify that only existing tax accounting items
of income, gain, deduction and loss (translated into U.S. dollars) should
be taken into account for purposes of calculating the dual consolidated loss
of a separate unit. In other words, treating a separate unit as a separate
domestic corporation does not cause items that are disregarded for U.S. tax
purposes (for example, interest paid by a disregarded entity on an obligation
held by its owner) to be regarded for purposes of calculating a separate unit’s
dual consolidated loss.

The proposed regulations also clarify that in the case of tiered separate
units, each separate unit must calculate its own dual consolidated loss and
no item of income, gain, deduction and loss may be taken into account in determining
the taxable income or loss of more than one separate unit. Similarly, the
proposed regulations clarify that items of one separate unit cannot offset
or otherwise be taken into account by another separate unit for purposes of
calculating a dual consolidated loss (unless the separate unit combination
rule applies). These rules ensure that the dual consolidated loss calculation
is computed separately for each separate unit, which is necessary to prevent
deductions and losses from being double-dipped.

(c) Foreign Branch Separate Unit

The proposed regulations provide that the asset use and business activities
principles of section 864(c) apply for purposes of determining the items of
income, gain, deduction (other than interest) and loss that are taken into
account in determining the taxable income or loss of a foreign branch separate
unit. For this purpose, the trading safe harbors of section 864(b) do not
apply for purposes of determining whether a trade or business exists within
a foreign country or whether income may be treated as effectively connected
to a foreign branch separate unit. In addition, the limitations on effectively
connected treatment of foreign source related-party income under section 864(c)(4)(D)
do not apply.

The proposed regulations further provide that the principles of §1.882-5,
as modified, apply for purposes of determining the items of interest expense
that are taken into account in determining the taxable income or loss of a
foreign branch separate unit. The rules provide that a taxpayer must use U.S.
tax principles to determine both the classification and amounts of the assets
and liabilities when the actual worldwide ratio is used. The valuation of
assets must be determined under the same methodology the taxpayer uses under
§1.861-9T(g) for purposes of allocating and apportioning interest expense
under section 864(e). Further, and solely for these purposes, the domestic
owner of the foreign branch separate unit is treated as a foreign corporation,
the foreign branch separate unit is treated as a trade or business within
the United States, and assets other than those of the foreign branch separate
unit are treated as assets that are not U.S. assets. Accordingly, only the
interest expense of the domestic owner of the foreign branch separate unit
is subject to allocation for purposes of computing the dual consolidated loss.
The IRS and Treasury believe that the application of these principles will
better harmonize the borrowing rate and effective interest costs that both
the United States and the foreign country take into account in determining
the dual consolidated loss, as compared to the use of §1.861-9T.

The IRS and Treasury believe that taking items into account in determining
the taxable income or loss of a foreign branch separate unit under these standards
is administrable because of the existing guidance provided under these provisions.
In addition, the IRS and Treasury believe that this approach furthers the
policy underlying section 1503(d) because it serves as a reasonable approximation
of the items that the foreign jurisdiction may recognize as being taken into
account in determining the taxable income or loss of a branch or permanent
establishment of a non-resident corporation in such jurisdiction. Nevertheless,
the IRS and Treasury solicit comments on these provisions and whether other
administrable approaches (that approximate the items taken into account by
the foreign jurisdiction) should be considered.

(d) Hybrid Entity

The proposed regulations provide rules for attributing items of income,
gain, deduction and loss to a hybrid entity. These rules are necessary to
determine the items that are attributable to an interest in a hybrid entity
that constitutes a separate unit.

The proposed regulations provide that, in general, the items of income,
gain, deduction and loss that are attributable to a hybrid entity are those
items that are properly reflected on its books and records, as adjusted to
conform to U.S. tax principles. The principles of §1.988-4(b)(2) apply
for purposes of making this determination. These principles generally provide
that the determination is a question of fact and must be consistently applied.
These principles also provide that the Commissioner may allocate items of
income, gain, deduction and loss between the domestic corporation (and intervening
entities, if any) that own the hybrid entity separate unit, and the hybrid
entity separate unit, if such items are not properly reflected on the books
and records of the hybrid entity.

The proposed regulations also provide that if a hybrid entity owns an
interest in either a non-hybrid entity partnership or a non-hybrid entity
grantor trust, items of income, gain, deduction and loss that are properly
reflected on the books and records of such partnership or grantor trust (under
the principles of §1.988-4(b)(2), as adjusted to conform to U.S. tax
principles), are treated as being properly reflected on the books and records
of the hybrid entity. However, such items are treated as being properly reflected
on the books and records of the hybrid entity only to the extent they are
taken into account by the hybrid entity under principles of subchapter K,
chapter 1 of the Code, or the principles of subpart E, subchapter J, chapter
1 of the Code, as the case may be.

The IRS and Treasury believe that attributing items to a hybrid entity
under this standard is administrable because it is generally consistent with
the accounting treatment of the items. The IRS and Treasury also believe
that this standard furthers the policy underlying section 1503(d) because
the items that are properly reflected on the books and records of the hybrid
entity (as adjusted to conform to U.S. tax principles) represent the best
approximation of items that the foreign jurisdiction would recognize as being
attributable to the entity. For example, it is likely that a foreign jurisdiction
would recognize and take into account as being attributable to a hybrid entity
the interest expense properly reflected on the books and records of the hybrid
entity; however, it is unlikely that a foreign jurisdiction would recognize,
and take into account as being attributable to a hybrid entity, interest expense
of a domestic corporation that owns an interest in the hybrid entity.

(e) Interest in a Disregarded Hybrid Entity

The proposed regulations provide that, except to the extent otherwise
provided under special rules (discussed below), items that are attributable
to an interest in a hybrid entity that is disregarded as an entity separate
from its owner are those items that are attributable to such hybrid entity
itself.

The proposed regulations provide rules for determining the extent to
which: (1) items of income, gain, deduction and loss that are attributable
to a hybrid entity that is a partnership are attributable to an interest in
such hybrid entity partnership; and (2) items of income, gain, deduction and
loss of a separate unit that is owned indirectly through a partnership are
taken into account by a partner in such partnership. These items are taken
into account to the extent they are includible in the partner’s distributive
share of the partnership income, gain, deduction or loss, as determined under
the rules and principles of subchapter K, chapter 1 of the Code.

The proposed regulations also provide rules for determining the extent
to which: (1) items of income, gain, deduction and loss attributable to a
hybrid entity that is a grantor trust are attributable to an interest in such
hybrid entity grantor trust; and (2) the items of income, gain, deduction
and loss of a separate unit owned indirectly through a grantor trust are taken
into account by an owner of such grantor trust. These items are taken into
account to the extent they are attributable to trust property that the holder
of the trust interest is treated as owning under the rules and principles
of subpart E, subchapter J, chapter 1 of the Code.

The proposed regulations provide special rules for allocating items
of income, gain, deduction and loss to foreign branch separate units that
are owned, directly or indirectly (other than through a hybrid entity separate
unit) by hybrid entities. In such a case, only items that are attributable
to the hybrid entity that owns such separate unit (and intervening entities,
if any, that are not themselves separate units) are taken into account.

This rule is intended to minimize the items taken into account by a
foreign branch separate unit that the foreign jurisdiction would not recognize
as being so taken into account. This may occur in these cases because the
foreign jurisdiction taxes the hybrid entity as a corporation (or otherwise
at the entity level) and therefore likely would not take into account items
of its owner. For example, if a domestic corporation indirectly owns a Country
X foreign branch separate unit through a Country Y hybrid entity, Country
X likely would take into account items of the Country Y hybrid entity as being
items of the Country X branch. It is unlikely, however, that Country X would
take into account items of the domestic corporation as items of the Country
X branch because Country X views the owner of the Country X branch (the Country
Y hybrid entity) as a corporation. Therefore, only the items of income, gain,
deduction and loss of the Country Y hybrid entity (and not items of the domestic
corporation) should be taken into account for purposes of determining the
dual consolidated loss of the Country X branch.

The proposed regulations also provide that only income and assets of
such hybrid entity are taken into account for purposes of applying the principles
of section 864(c) and §1.882-5, as modified, in determining the items
taken into account by the foreign branch separate unit; thus, other income
and assets of the domestic owner, for example, are not taken into account
for these purposes. This rule is also intended to ensure that the principles
under these provisions are applied in a way that best approximates the items
that the foreign jurisdiction would recognize as being taken into account
by a taxable presence in such jurisdiction.

Finally, the proposed regulations provide that items generally attributable
to an interest in a hybrid entity are not taken into account to the extent
they are taken into account by a foreign branch separate unit owned, directly
or indirectly (other than through a hybrid entity separate unit), by the hybrid
entity. This rule prevents two or more separate units from taking into account
the same item of income, gain, deduction or loss under different rules.

(h) Combined Separate Units

As discussed above, the proposed regulations combine separate units
owned, directly or indirectly, by a single domestic corporation, provided
certain requirements are satisfied. Because different rules may apply for
purposes of attributing items to individual separate units that may be combined
into a single separate unit, special rules are necessary to attribute items
to combined separate units.

The proposed regulations provide that in the case of a combined separate
unit, items are first attributable to, or otherwise taken into account by,
the individual separate units composing the combined separate unit, without
regard to the combination rule. The combined separate unit then takes into
account all of the items attributable to, or taken into account by, the individual
separate units that compose such combined separate unit.

(i) Gain or Loss Recognized on Dispositions of Separate Units

The current regulations do not indicate whether items of income, gain,
deduction and loss recognized on the sale or disposition of a separate unit,
or of an interest in a partnership or grantor trust through which a separate
unit is indirectly owned, is attributable to or taken into account by such
separate unit for purposes of calculating the dual consolidated loss of the
separate unit for the year of the sale (or for purposes of reducing the amount
of recapture as a result of a triggering event).

The IRS and Treasury believe that it is appropriate to take into account
items of income, gain, deduction and loss recognized on these dispositions.
Thus, the proposed regulations provide that items of income, gain, deduction
and loss recognized on the disposition of a separate unit (or an interest
in a partnership or grantor trust that directly or indirectly owns a separate
unit), are attributable to or taken into account by the separate unit to the
extent of the gain or loss that would have been recognized had such separate
unit sold all its assets in a taxable exchange, immediately before the disposition
of the separate unit, for an amount equal to their fair market value. The
proposed regulations clarify that for this purpose items of income and gain
include loss recapture income or gain under section 367(a)(3)(C) or 904(f)(3).

The proposed regulations also address situations where more than one
separate unit is disposed of in the same transaction and items of income,
gain, deduction and loss recognized on such disposition are attributable to
more than one separate unit. In such a case, items of income, gain, deduction
and loss are attributable to or taken into account by each such separate unit
based on the gain or loss that would have been recognized by each separate
unit if it had sold all of its assets in a taxable exchange, immediately before
the disposition of the separate unit, for an amount equal to their fair market
value.

(j) Income Inclusion on Stock

The current regulations do not indicate whether an amount included in
income arising from the ownership of stock in a foreign corporation (income
inclusion) is attributable to or taken into account by a separate unit that
owns the stock that gave rise to the income inclusion. For example, if a
domestic corporation has a section 951(a) inclusion attributable to stock
of a controlled foreign corporation that is owned by a hybrid entity separate
unit, it is not clear under the current regulations whether such income inclusion
is taken into account for purposes of calculating the dual consolidated loss
of the hybrid entity separate unit.

The IRS and Treasury believe that, solely for purposes of applying the
dual consolidated loss rules, it is appropriate to treat income inclusions
arising from the ownership of stock in the same manner that dividend income
is treated. Accordingly, the proposed regulations provide that income inclusions
are taken into account for purposes of calculating the dual consolidated loss
of a separate unit if an actual dividend from such foreign corporation would
have been so taken into account.

(k) Section 987 Gain or Loss

Section 987 provides that if a taxpayer has one or more qualified business
units with a functional currency other than the dollar, the taxpayer must
make proper adjustments to take into account foreign currency gain or loss
on certain transfers of property between such qualified business units.

In 1991, the IRS and Treasury issued proposed regulations under section
987 that included rules for determining the amount of foreign currency gain
or loss recognized on certain transfers of property between qualified business
units. On April 3, 2000, the IRS and Treasury issued Notice 2000-20, 2000-14
I.R.B. 851, announcing that the IRS and Treasury intend to review and possibly
replace the proposed regulations issued under section 987. The IRS and Treasury
have opened a regulations project under section 987 and expect to issue new
section 987 regulations in the future.

The current regulations do not provide specific rules that indicate
whether section 987 gains or losses of a domestic owner are attributable to,
or taken into account by, a separate unit for purposes of calculating the
separate unit’s dual consolidated loss. Because the IRS and Treasury
have an open regulations project under section 987 and expect to issue new
regulations under section 987, the IRS and Treasury do not believe it is appropriate
to address this issue in the proposed regulations. The IRS and Treasury request
comments on whether section 987 gains and losses of a domestic owner should
be attributable to, or taken into account by, a separate unit, particularly
with respect to section 987 gains and losses attributable to, or taken into
account by, separate units owned indirectly through hybrid entity separate
units.

2. Effect of a dual consolidated loss

Section 1.1503-2(d)(2) of the current regulations provides that if a
dual resident corporation has a dual consolidated loss that is subject to
the general rule restricting it from offsetting the income of a domestic affiliate,
the consolidated group of which the dual resident corporation is a member
must compute its taxable income without taking into account the items of income,
gain, deduction or loss taken into account in computing the dual consolidated
loss. The current regulations contain a similar rule for separate units.

These rules do not exclude only the dual consolidated loss in computing
taxable income, but instead provide that none of the gross tax accounting
items that compose the dual consolidated loss are taken into account. While
this approach has the same effect on net income as would excluding only the
dual consolidated loss, removing all gross items of income, gain, deduction
and loss may have a distortive effect on other federal tax calculations.

The IRS and Treasury believe that this distortive effect will be minimized
if only the dual consolidated loss itself is not taken into account. Accordingly,
the proposed regulations provide that only a pro rata portion
of each item of deduction and loss taken into account in computing the dual
consolidated loss are excluded in computing taxable income. In addition,
to the extent that a dual consolidated loss is carried over or carried back
and, subject to §1.1502-21(c) (as modified in the proposed regulations),
is made available to offset income generated by the dual resident corporation
or separate unit, the proposed regulations treat items composing the dual
consolidated loss as being used on a pro rata basis.

3. Basis adjustments

Section 1.1503-2(d)(3) of the current regulations contains special basis
adjustment rules that override the normal investment adjustment rules under
§1.1502-32 for stock of affiliated dual resident corporations or affiliated
domestic owners owned by other members of the consolidated group. These rules
provide that stock basis is reduced by a dual consolidated loss, even though
such loss is subject to the general limitation on the use of a dual consolidated
loss to offset income of a domestic affiliate. To avoid reducing the stock
basis a second time for the same dual consolidated loss, the rules also provide
that no negative adjustment shall be made for the amount of dual consolidated
loss subject to the general limitation that is subsequently absorbed in a
carryover or carryback year. Finally, the rules provide that there is no
basis increase for recapture income recognized as a result of a triggering
event. Similar rules apply to separate units arising from ownership of an
interest in a partnership. These special basis adjustment rules are generally
intended to prevent an indirect deduction of a dual consolidated loss.

The proposed regulations retain the special stock basis adjustment rules,
as modified, to prevent the indirect use of a dual consolidated loss. In
addition, the proposed regulations retain the rules addressing the effect
of a dual consolidated loss on a partner’s adjusted basis in its partnership
interest in cases where the partnership interest is a separate unit, or a
separate unit is owned indirectly through a partnership. These rules require
the partner to adjust its basis in accordance with the principles of section
705, subject to certain modifications.

The IRS and Treasury recognize that these rules may lead to harsh results,
particularly in light of the fact that the indirect use of the dual consolidated
loss would only arise through the disposition of the stock of a dual resident
corporation (or a partnership interest) that may not occur for many years
after the dual consolidated loss is incurred. In addition, upon such subsequent
disposition the resulting deduction or loss would generally be capital in
nature, and the definition of a dual consolidated loss excludes capital losses
incurred by the dual resident corporation or separate unit. As a result,
the IRS and Treasury request comments regarding concerns over these types
of indirect uses and whether the special basis rules should be retained.
These comments should consider whether the policies underlying section 1503(d)
require basis adjustment rules that differ from other basis adjustment rules
that apply to non-capital, non-deductible expenses (for example, rules under
sections 705 and 1367, and §1.1502-32(b))

E. Exceptions to the Domestic Use Limitation Rule —
§1.1503(d)-4

1. No possibility of foreign use

The proposed regulations provide a new exception to the general rule
prohibiting the domestic use of a dual consolidated loss. To qualify under
this exception, the consolidated group, unaffiliated dual resident corporation,
or unaffiliated domestic owner must: (1) demonstrate, to the satisfaction
of the Commissioner, that there can be no foreign use of the dual consolidated
loss at any time; and (2) prepare a statement and attach it to its tax return
for the taxable year in which the dual consolidated loss is incurred. This
statement must include an analysis, in reasonable detail and specificity,
supported with an official or certified English translation of the relevant
provisions of foreign law, of the treatment of the losses and deductions composing
the dual consolidated loss, and the reasons supporting the conclusion that
there cannot be a foreign use of the dual consolidated loss by any means at
any time.

This exception is intended to replace the exception to the definition
of a dual consolidated loss contained in §1.1503-2(c)(5)(ii)(A) of the
current regulations. Thus, under the proposed regulations the question of
foreign use is not relevant to the definition of a dual consolidated loss;
the issue will instead be whether an exception to the domestic use limitation
applies. Consistent with the exception to the definition of a dual consolidated
loss contained in the current regulations, the IRS and Treasury believe that
this new exception to the domestic use limitation rule contained in the proposed
regulations will apply only in rare and unusual circumstances due to the definition
of foreign use and general principles of foreign law. For example, if the
foreign jurisdiction recognizes any item of deduction or loss composing the
dual consolidated loss (regardless of whether recognized currently or deferred,
for example, by being reflected in the basis of assets), and such item is
available for foreign use through a form of consolidation, carryover or carryback,
or a transaction (for example, a merger, basis carryover transaction, or entity
classification election), then the exception will not apply.

2. Domestic use election and agreement

As discussed above, the current regulations provide an exception to
the general rule prohibiting the use of a dual consolidated loss to offset
the income of a domestic affiliate if a (g)(2)(i) election is made. Under
this exception, the consolidated group, unaffiliated dual resident corporation,
or unaffiliated domestic owner must enter into an agreement ((g)(2)(i) agreement)
certifying, among other things, that no portion of the deductions or losses
taken into account in computing the dual consolidated loss have been, or will
be, used to offset the income of any other person under the income tax laws
of a foreign country.

The proposed regulations retain this elective exception, with modifications,
and refer to it as a domestic use election. In addition,
the proposed regulations refer to the consolidated group, unaffiliated dual
resident corporation, or unaffiliated domestic owner, as the case may be,
that makes a domestic use election as an elector. In
order to elect relief under this exception, the proposed regulations require
the elector to enter into a domestic use agreement, which is similar to the
(g)(2)(i) agreement required by the current regulations.

3. Certification period

Under the current regulations, a (g)(2)(i) agreement generally provides
that if there is a triggering event during the 15-year period following the
year in which the dual consolidated loss was incurred (certification period),
the taxpayer must recapture and report as income the amount of the dual consolidated
loss, and pay an interest charge. See §1.1503-2(g)(2)(iii)(A).

Commentators have questioned whether under the current regulations the
15-year certification period applies only to the use triggering event, or
whether it applies to all triggering events. These commentators note that,
under this interpretation, triggering events other than use could occur after
the expiration of the certification period. The IRS and Treasury believe
that the certification period applies to all triggering events. Accordingly,
the proposed regulations clarify that all triggering events are subject to
the certification period and, therefore, a triggering event cannot occur after
the expiration of the certification period.

The IRS and Treasury also believe that a 15-year certification period
is not required to deter and monitor double-dipping of losses and deductions.
Moreover, the IRS and Treasury believe that requiring taxpayers to comply
with the dual consolidated loss regulations, including the need to monitor
potential triggering events and to comply with the various filing requirements,
for a 15-year period is unnecessarily burdensome to both taxpayers and the
Commissioner. As a result, the proposed regulations reduce the certification
period from 15 years to seven years with respect to a domestic use election.

4. Consistency rule

Section 1.1503-2(g)(2)(ii) of the current regulations contains a consistency
rule. Under this rule, if any losses, expenses, or deductions taken into
account in computing the dual consolidated loss of a dual resident corporation
or separate unit are used to offset the income of another person under the
laws of a single foreign country while the dual resident corporation or separate
unit is owned by the domestic owner or member of the consolidated group, the
losses, expenses, or deductions taken into account in computing the dual consolidated
losses of other dual resident corporations or separate units owned by the
same consolidated group (or other separate units owned by the unaffiliated
domestic owner of the first separate unit) in that year are deemed to offset
income of another person in the same foreign country. This rule only applies,
however, if such losses, expenses, or deductions are recognized in the foreign
country in the same taxable year. Moreover, this rule does not apply if,
under foreign law, the other dual resident corporation or separate unit cannot
use its losses, expenses, or deductions to offset income of another person
in such taxable year.

The consistency rule is intended to ensure that a consolidated group
or domestic owner treats uniformly all dual consolidated losses of dual resident
corporations or separate units that it owns that are available for use in
a foreign country in a given year. The rule is also intended to minimize the
administrative burden associated with identifying the items of loss or deduction
of a particular dual consolidated loss that are used to offset income of another
person under the income tax laws of a foreign country.

Commentators have questioned the need for the consistency rule, noting
that it can lead to harsh results.

The IRS and Treasury believe that, despite concerns raised by commentators,
the consistency rule continues to be necessary to promote the uniform treatment
of dual consolidated losses of dual resident corporations and separate units
owned by the consolidated group or domestic owner, and to minimize administrative
burdens. As a result, the proposed regulations retain the consistency rule,
as modified.

In addition, the proposed regulations clarify that the consistency rule
only applies to a dual consolidated loss that is subject to a domestic use
agreement (other than a new domestic use agreement). In other words, the
proposed regulations clarify that the consistency rule does not apply to a
foreign use of a dual consolidated loss that occurs subsequent to a triggering
event that terminates the domestic use agreement filed with respect to such
dual consolidated loss.

5. Restrictions on domestic use elections

The current regulations do not explicitly address situations where a
triggering event (discussed below) with respect to a dual consolidated loss
occurs in the year in which the dual consolidated loss is incurred. The proposed
regulations, however, make clear that a domestic use election cannot be made
for a dual consolidated loss incurred in the same year in which a triggering
event with respect to such loss occurs.

The current regulations also do not explicitly address the application
of section 953(d)(3) (limiting losses of foreign insurance companies that
elect to be treated as domestic corporations). The proposed regulations,
however, provide that a foreign insurance company that has elected to be treated
as a domestic corporation pursuant to section 953(d) may not make a domestic
use election. This rule is consistent with section 953(d)(3), which broadly
prohibits regulatory exceptions to the general prohibition on the domestic
use of dual consolidated losses in such cases.

6. Triggering events

(a) In General

Section 1.1503-2(g)(2)(iii) of the current regulations provides rules
relating to certain events which require the recapture of previously allowed
dual consolidated losses. Under these rules, if a consolidated group, unaffiliated
dual resident corporation, or unaffiliated domestic owner, as the case may
be, makes a (g)(2)(i) election, the dual resident corporation or separate
unit must recapture, and the consolidated group, unaffiliated dual resident
corporation or unaffiliated domestic owner must report as income the amount
of the dual consolidated loss (and pay an interest charge) if a triggering
event occurs during the certification period. Taxpayers may, however, rebut
these triggering events upon making certain showings to the satisfaction of
the Commissioner.

The proposed regulations generally retain the triggering event rules
contained in the proposed regulations, as modified, if a taxpayer makes a
domestic use election.

(b) Carryover of Losses, Deductions, and Basis

Under the current regulations, certain asset transfers by a dual resident
corporation that result, under the laws of a foreign country, in a carryover
of losses, expenses, or deductions are triggering events. The current regulations
contain a similar rule for such transfers by separate units. See §1.1503-2(g)(2)(iii)(A)(4)
and (5).

The proposed regulations retain these triggering events, as modified,
and combine them into a single triggering event. The proposed regulations
also clarify that certain asset transfers that result in the carryover of
basis in assets under the laws of a foreign country also qualify as triggering
events. This is the case because asset basis generally will, at some point
in the future, be converted into a loss or deduction as a result of the depreciation,
amortization or disposition of the asset. Accordingly, under foreign law,
a transaction that results in the carryover of asset basis generally has the
same effect as a transaction that results in the carryover of losses or deductions
and therefore should be treated similarly.

(c) Disposition by a Separate Unit or Dual Resident Corporation
of an Interest in a Separate Unit or Stock of a Dual Resident Corporation

The current regulations provide that certain sales or other dispositions
of 50 percent or more of the assets of a separate unit or dual resident corporation
are deemed to be triggering events. See §1.1503-2(g)(2)(iii)(A)(4)
and (5). For this purpose, an interest in a separate
unit and stock of a dual resident corporation are treated as assets of the
separate unit or dual resident corporation. One commentator stated that,
as a result of this rule, the disposition of an interest in one separate unit
by another separate unit may inappropriately result in a triggering event
for both separate units. Accordingly, the commentator suggested that the
disposition of the interest in the lower-tier separate unit should not result
in a triggering event with respect to dual consolidated losses of the separate
unit that disposed of such interest.

The IRS and Treasury believe that the disposition of an interest in
a lower-tier separate unit (or the shares of a dual resident corporation)
by an upper-tier separate unit (or dual resident corporation) typically will
not result in the carryover of the dual consolidated loss of the upper-tier
separate unit (or dual resident corporation) under the laws of the foreign
jurisdiction such that it could be put to a foreign use. Therefore, the proposed
regulations provide that for purposes of determining whether 50 percent or
more of the separate unit’s or dual resident corporation’s assets
is disposed of, an interest in a separate unit and the stock of a dual resident
corporation shall not be treated as assets of the separate unit or dual resident
corporation making such disposition. The IRS and Treasury request comments
as to other assets the disposition of which should be excluded from the 50
percent test under this triggering event.

(d) Fifty Percent Threshold for Asset Transfer Triggering
Events

Section 1.1503-2(g)(2)(iii)(A)(7) of the current
regulations provides that a triggering event occurs if, within a 12-month
period, the domestic owner of a separate unit disposes of 50 percent or more
(by voting power or value) of the interest in the separate unit that was owned
by the domestic owner on the last day of the taxable year in which the dual
consolidated loss was incurred. As noted above, the current regulations also
provide that a triggering event occurs if a domestic owner of a separate unit
transfers assets of the separate unit in a transaction that results, under
the laws of a foreign country, in a carryover of the separate unit’s
losses, expenses, or deductions. Section 1.1503-2(g)(2)(iii)(A)(5).
Moreover, the current regulations deem such an asset transfer to be a triggering
event if 50 percent or more of the separate unit’s assets (measured
by fair market value at the time of transfer) are disposed of within a 12-month
period.

One commentator noted that the two triggering events discussed above
operate differently in that any transfer of assets of a separate unit may
constitute a triggering event, while the transfer of an interest in a separate
unit constitutes a triggering event only if a 50 percent threshold is met.

The IRS and Treasury believe that these two triggering events should
operate in a consistent manner. As a result, the proposed regulations provide
that both the asset transfer triggering event and the separate unit interest
transfer triggering event occur only if a 50 percent threshold is satisfied.
It should be noted, however, that transfers of assets of a dual resident
corporation or separate unit, and transfers of interests of separate units,
in many cases will subsequently result in a foreign use triggering event,
even though the 50 percent threshold for the asset transfer triggering event
and the separate unit interest transfer triggering event are not satisfied.
For example, if a domestic owner of an interest in a hybrid entity separate
unit transfers 25 percent of its interest in the hybrid entity separate unit
to a foreign corporation, all or a portion of a dual consolidated loss attributable
to such separate unit in a prior year may be available to offset subsequent
income of the owner of the transferred interest (that is not a separate unit
after such transfer because it is held by a foreign corporation) and therefore
may result in a foreign use triggering event.

(d) S Corporation Conversion

Under the current regulations, if either an affiliated dual resident
corporation or an affiliated domestic owner that has filed a (g)(2)(i) agreement
with respect to a dual consolidated loss elects to be an S corporation pursuant
to section 1362(a), such election results in a triggering event because it
terminates the consolidated group and the affiliated dual resident corporation
or affiliated domestic owner ceases to be a member of a consolidated group.
See §1.1503-2(g)(2)(iii)(A)(2). The current regulations
do not, however, address an election to be an S corporation by either an unaffiliated
dual resident corporation or an unaffiliated domestic owner that has made
a (g)(2)(i) election.

The IRS and Treasury believe that the election by an unaffiliated dual
resident corporation or unaffiliated domestic owner to be an S corporation
should be treated in the same manner as an election by an affiliated dual
resident corporation or affiliated domestic owner that is a member of a consolidated
group. Accordingly, the proposed regulations add as a new triggering event
the election of either an unaffiliated dual resident corporation or unaffiliated
domestic owner to be an S corporation.

(f) Consolidated Group Remains in Existence

As stated above, and subject to exceptions, the current regulations
provide that a triggering event occurs with respect to a dual consolidated
loss of an affiliated dual resident corporation or affiliated domestic owner
if such dual resident corporation or affiliated domestic owner ceases to be
a member of the consolidated group of which it was a member when the dual
consolidated loss was incurred. The current regulations also provide that
an affiliated dual resident corporation or affiliated domestic owner is considered
to cease to be a member of a consolidated group if the consolidated group
ceases to exist (group termination triggering event) because, for example,
the common parent is no longer in existence. Section 1.1503-2(g)(2)(iii)(A)(2).

One commentator stated that language contained in Revenue Procedure
2000-42, 2000-2 C.B. 394, may imply that there is a group termination triggering
event if the common parent of a consolidated group that made a (g)(2)(i) election
ceases to exist, or is a party to a reverse acquisition, even though the consolidated
group remains in existence. This interpretation is contrary to the principles
underlying the triggering events. Accordingly, the proposed regulations clarify
that such transactions do not constitute group termination triggering events.
See §1.1503(d)-5(c) Example 47.

7. Rebuttal of triggering events

Under the current regulations, taxpayers may rebut all but two of the
triggering events such that there is no dual consolidated loss recapture (or
related interest charge) as a result of a putative triggering event. In general,
under the current regulations, a triggering event is rebutted if the taxpayer
demonstrates to the satisfaction of the Commissioner that, depending on the
triggering event, either: (1) the losses, expenses or deductions of the dual
resident corporation (or separate unit) cannot be used to offset income of
another person under the laws of a foreign country or; (2) the transfer of
assets did not result in a carryover under foreign law of the losses, expenses,
or deductions of the dual resident corporation (or separate unit) to the transferee
of the assets. See §1.1503-2(g)(2)(iii)(A)(2) through
(7). The policies underpinning the dual consolidated
loss rules do not require recapture or an interest charge in such cases because
there is no opportunity for any portion of the dual consolidated loss to be
used to offset income of any other person under the income tax laws of a foreign
country.

The rebuttal rules impose a standard of proof on taxpayers that in many
cases is difficult and burdensome to meet, even though there may be little
likelihood that any portion of the dual consolidated loss could be used to
offset the income of any other person under the income tax laws of a foreign
country. For example, demonstrating that no portion of the dual consolidated
loss can be used by another person as a result of typical loss carryover transactions
under foreign law may not satisfy the burden if there is some potential that
any portion of losses or deductions composing the dual consolidated loss could
be so used as a result of a transaction that is rare, commercially impractical,
or not reasonably foreseeable. In addition, because there are often significant
differences between U.S. and foreign law, ruling out the various types of
transactions that under U.S. law would allow all or a portion of the dual
consolidated loss to be used by another person also may not be sufficient
to rebut a triggering event.

Commentators have noted that under the current regulations it may not
be possible to rebut certain triggering events if the tax basis of a single
asset carries over to another person under foreign law, even though as a result
of the transaction recognized losses and accrued deductions generally do not
carry over to another person under foreign law. This is the case because
the person that receives the carryover asset basis may at some point in the
future enjoy the benefit of a loss or deduction as a result of the depreciation,
amortization or disposition of the asset. As a result, the carryover of a
nominal amount of asset tax basis causes the entire dual consolidated loss
to be recaptured. Similar issues arise in connection with assumptions of
liabilities that, for example, result in deductions for U.S. tax purposes
on an accrual basis, but are deductible under the laws of the foreign jurisdiction
at a later time when paid. This result is consistent with the all
or nothing principle, discussed below.

The IRS and Treasury recognize that in some of these cases the use of
a portion of a dual consolidated loss may be denied in both the United States
and the foreign jurisdiction. Further, commentators have stated that denying
a loss or deduction from offsetting income in both the United States and the
foreign jurisdiction generally is inconsistent with the principles underlying
section 1503(d) because the statute’s purpose is to prevent the use
of the same loss or deduction to offset income in multiple jurisdictions.

The proposed regulations retain the rebuttal standard contained in the
current regulations, with modifications. Taxpayers may rebut a triggering
event under the proposed regulations if it can be demonstrated, to the satisfaction
of the Commissioner, that there can be no foreign use of the dual consolidated
loss. In addition, unlike the current regulations that have different standards
for different triggering events, the proposed regulations apply the same standard
to all triggering events (other than a foreign use triggering event, which
cannot be rebutted).

The IRS and Treasury believe that when the proposed regulations are
finalized the number of transactions undertaken by taxpayers that result in
triggering events will be significantly reduced, as compared to the current
regulations, because of the significant reduction in the term of the certification
period. Nevertheless, the IRS and Treasury believe that the current rebuttal
standard may exceed that required to address adequately the concern that all
or a portion of a dual consolidated loss could be put to a foreign use. Moreover,
the IRS and Treasury believe that more definitive and administrable rebuttal
rules should be provided to assist taxpayers and the Commissioner in determining
whether the triggering event has been rebutted, and to minimize situations
where there is recapture of a dual consolidated loss even though it may be
unlikely that a significant portion of the dual consolidated loss could be
put to a foreign use. Therefore, it is anticipated that, prior to the finalization
of these proposed regulations, a revenue procedure will be issued that will
provide safe harbors whereby triggering events will be deemed to be rebutted
if the taxpayer satisfies various conditions. The revenue procedure may be
issued in proposed form and then made final contemporaneously with these regulations.

It is anticipated that the conditions contained in the revenue procedure
would include the requirement that taxpayers demonstrate, to the satisfaction
of the Commissioner, that there can be no foreign use of any significant portion
of the dual consolidated loss as a result of certain enumerated transactions.
It is also anticipated that the revenue procedure will address, and in some
cases provide relief for, transactions that result in a de minimis carry
over of asset basis under foreign law and are difficult or impossible to rebut
under the current regulations. Finally, the revenue procedure may provide
relief for triggering events resulting from the assumption of liabilities
in connection with the acquisition of a trade or business as a result of liabilities
incurred in the ordinary course of business being deductible at different
times under U.S. law and the law of the foreign jurisdiction.

The IRS and Treasury request comments regarding the transactions that
should be included in the revenue procedure, approaches to address basis carryover
transactions and liabilities assumed in the ordinary course of business, and
other ways to minimize the administrative burden associated with rebutting
the triggering events, while ensuring that there is little or no likelihood
that a significant portion of the dual consolidated loss can be put to a foreign
use.

8. Triggering event exception for acquisition by an unaffiliated
domestic corporation or a new consolidated group

Section 1.1503-2(g)(2)(iv)(B)(1) of the current
regulations provides that if certain requirements are satisfied, the following
events do not constitute triggering events: (1) an affiliated dual resident
corporation or affiliated domestic owner becomes an unaffiliated domestic
corporation or a member of a new consolidated group (unless such transaction
also qualifies under another exception); (2) assets of a dual resident corporation
or a separate unit are acquired by an unaffiliated domestic corporation or
a member of a new consolidated group; or (3) a domestic owner of a separate
unit transfers its interest in the separate unit to an unaffiliated domestic
corporation or to a member of a new consolidated group.

The first requirement necessary for this exception to apply is that
the consolidated group, unaffiliated dual resident corporation, or unaffiliated
domestic owner that made the (g)(2)(i) election, and the unaffiliated domestic
corporation or new consolidated group must enter into a closing agreement
with the IRS providing that both parties will be jointly and severally liable
for the total amount of the recapture of the dual consolidated loss and interest
charge upon a subsequent triggering event. Second, the unaffiliated domestic
corporation or new consolidated group must agree to treat any potential recapture
as unrealized built-in gain for purposes of section 384, subject to any applicable
exceptions thereunder. Finally, the unaffiliated domestic corporation or
new consolidated group must file with its timely filed income tax return for
the year in which the event occurs a (g)(2)(i) agreement (new (g)(2)(i) agreement),
whereby it assumes the same obligations with respect to the dual consolidated
loss as the corporation or consolidated group that filed the original (g)(2)(i)
agreement with respect to that loss.

On July 30, 2003, the IRS and Treasury issued final regulations (T.D.
9084, 2003-2 C.B. 742) (2003 regulations), published in the Federal
Register at 68 FR 44616, that limited the need for closing agreements
to avoid triggering events to only those three transactions described above.
The preamble to the 2003 regulations explained that in certain cases the requirement
for a closing agreement resulted in an unnecessary administrative burden because
the several liability imposed by §1.1502-6, in conjunction with the original
(g)(2)(i) agreement and a new (g)(2)(i) agreement, provided for liability
sufficiently comparable to that imposed under a closing agreement. Accordingly,
the 2003 regulations provided that if a new (g)(2)(i) agreement is filed by
the unaffiliated domestic corporation or new consolidated group, a closing
agreement is not required in the following two instances: (1) an unaffiliated
dual resident corporation or unaffiliated domestic owner that filed a (g)(2)(i)
agreement becomes a member of a consolidated group; and (2) a consolidated
group that filed a (g)(2)(i) agreement ceases to exist as a result of a transaction
described in §1.1502-13(j)(5)(i) (unless a member of the terminating
group, or successor-in-interest of such member, is not a member of the surviving
group immediately after the terminating group ceases to exist).

The preamble to the 2003 regulations noted that the IRS and Treasury
were continuing to consider other alternatives to further reduce the administrative
and compliance burdens under section 1503(d). After further consideration,
the IRS and Treasury believe that, as a result of various requirements contained
in the proposed regulations, there are sufficient protections, independent
of a closing agreement, in all cases in which a closing agreement is otherwise
required under the current regulations. As a result, the proposed regulations
eliminate the closing agreement requirement contained in the current regulations
and provide an exception to triggering events in all such cases (subsequent
elector events) if: (1) the unaffiliated domestic corporation or new consolidated
group (subsequent elector) enters into a domestic use agreement (new domestic
use agreement); and (2) the corporation or consolidated group that filed the
original domestic use agreement (original elector) files a statement with
its tax return for the year of the event.

Pursuant to the new domestic use agreement, the subsequent elector must:
(1) agree to assume the same obligations with respect to the dual consolidated
loss as the original elector had pursuant to its domestic use agreement; (2)
agree to treat any potential recapture of the dual consolidated loss at issue
as unrealized built-in gain pursuant to section 384, subject to any applicable
exceptions thereunder; (3) agree to be subject to the successor elector rules,
discussed below; and (4) identify the original elector (and subsequent electors,
if any). Pursuant to the statement filed by the original elector, the original
elector must agree to be subject to the subsequent elector rules and must
identify the subsequent elector.

Under the current regulations, only specific triggering events can qualify
for an exception as a result of the parties entering into a closing agreement.
Therefore, the IRS will not consider entering into a closing agreement in
other circumstances, even though the government’s interests may be adequately
protected in such circumstances such that recapture may not be necessary.

Although the proposed regulations eliminate the need for a closing agreement
to qualify for an exception to triggering events, discussed above, the IRS
and Treasury are considering whether in limited cases it may be appropriate
for the Commissioner, in its sole discretion and subject to the taxpayer satisfying
conditions specified by the Commissioner, to enter into closing agreements
with taxpayers such that certain other events would not be triggering events.
Comments are requested as to the specific and limited types of triggering
events that may be suitable for this exception, taking into account the policies
underlying section 1503(d), administrative burdens, and the general interests
of the U.S. government.

10. Annual certification reporting requirement

Section 1.1503-2T(g)(2)(vi)(B) of the current regulations provides that
if a (g)(2)(i) election is made with respect to a dual consolidated loss of
a dual resident corporation or a hybrid entity separate unit, the consolidated
group, unaffiliated dual resident corporation, or unaffiliated domestic owner,
as the case may be, must file with its tax return an annual certification
during the certification period. This filing certifies that the losses or
deductions that make up the dual consolidated loss have not been used to offset
the income of another person under the tax laws of a foreign country. The
filing also warrants that arrangements have been made to ensure that there
will be no such use of the dual consolidated loss and that the taxpayer will
be informed if any such use were to occur. The current regulations do not,
however, require annual certifications for dual consolidated losses of foreign
branch separate units.

The IRS and Treasury believe that annual certifications of dual consolidated
losses improve taxpayer compliance with the dual consolidated loss rules and
are beneficial to the Commissioner in monitoring such compliance. The IRS
and Treasury also believe that foreign branch separate units, hybrid entity
separate units, and dual resident corporations should, to the extent possible,
be treated consistently to reduce complexity. As a result, the proposed regulations
expand the annual certification requirement to include dual consolidated losses
of foreign branch separate units. However, the reduction in the certification
period from 15 years to seven years should substantially reduce the overall
compliance burden of this requirement.

11. Amount of recapture

As stated above, under the current regulations a triggering event (other
than a foreign use) generally can be rebutted only if no portion of the dual
consolidated loss can be used by (or carries over to) another person under
foreign law. See §1.1503-2(g)(2)(iii)(A)(2) through
(7). Thus, if even a de minimis portion
of the dual consolidated loss can be used by (or carries over to) another
person, the triggering event cannot be rebutted. Similarly, §1.1503-2(g)(2)(vii)(A)
of the current regulations provides that if a triggering event occurs, the
entire dual consolidated loss subject to the (g)(2)(i) agreement (reduced
by income earned subsequently by the dual resident corporation or separate
unit) is recaptured and reported as income, regardless of the amount of the
dual consolidated loss used by the other person. Thus, even a de
minimis foreign use will cause the entire amount of the dual consolidated
loss to be recaptured and reported as income.

This so-called all or nothing principle is included
in the current regulations primarily due to administrative concerns. In many
cases, the exact amount of the dual consolidated loss that is used by another
person cannot be readily determined. This inability is due, in part, to differences
between U.S. and foreign law. For example, there may be temporary and permanent
differences in the treatment of items of income, gain, deduction and loss.
There may also be differences in loss carryover provisions. These concerns
are exacerbated by the principle that certain deductions are fungible and,
therefore, cannot easily be traced to a particular loss incurred in a particular
year.

Commentators have noted that in some cases the all or nothing principle
results in a disallowance of deductions in both the United States and the
foreign jurisdiction. Nevertheless, the IRS and Treasury believe that making
a precise determination as to the amount of the dual consolidated loss put
to a foreign use would require the Commissioner and taxpayers to analyze foreign
law in great detail and, in some cases, compare the treatment of items under
foreign law with their treatment under U.S. law. Such an analysis, however,
is inconsistent with the principle underlying the regulations that, to the
extent possible, the Commissioner and taxpayers should not be required to
analyze foreign law. Moreover, departing from the all or nothing principle
would likely require detailed ordering, stacking, and tracing rules to determine
the amount and nature of dual consolidated losses that are recaptured upon
a use. Such rules would add considerable complexity to the regulations.
As a result, the proposed regulations retain the all or nothing rule
contained in the current regulations. However, the IRS and Treasury request
comments regarding administrable alternatives to the all or nothing rule
that would not involve substantial analyses of foreign law. For example,
comments are requested as to whether a pro rata recapture
rule with respect to dispositions of separate units would be consistent with
the general framework of the proposed regulations and would be administrable.

12. Subsequent elector rules

Neither the current regulations nor Rev. Proc. 2000-42, 2000-2 C.B.
394, explicitly address the consequences resulting from a triggering event
(to which no exception applies) with respect to a dual consolidated loss that
was not recaptured due to an earlier triggering event as a result of the parties
entering into a closing agreement. In such a case, both parties are jointly
and severally liable for the total amount of the recapture of the dual consolidated
loss and interest charge resulting from such a subsequent triggering event.
However, it is unclear which taxpayer must report the recapture income (and
related interest charge) on its tax return upon the subsequent triggering
event. In addition, there is little or no procedural guidance outlining how,
pursuant to a closing agreement, the IRS would collect recapture tax and the
related interest charge from the parties to the closing agreement.

Accordingly, the proposed regulations contain rules regarding subsequent
electors. These rules apply when, subsequent to an event that is not a triggering
event because the unaffiliated domestic corporation or new consolidated group
enters into a new domestic use agreement and satisfies other requirements
(excepted event), a triggering event occurs, and no exception applies to such
event (subsequent triggering event). The proposed regulations also provide
rules that apply in the case of multiple subsequent electors (when subsequent
to an excepted event, another excepted event occurs).

The proposed regulations first provide that, except to the extent provided
under the subsequent elector rules, the original elector (and in the case
of multiple excepted events, any prior subsequent elector) is not subject
to the general recapture and interest charge rules provided under the regulations.
As a result, only the subsequent elector that owns the dual resident corporation
or separate unit at the time of the subsequent triggering event is subject
to the general recapture and interest charge rules.

The proposed regulations also provide that, upon a subsequent triggering
event to which no exception applies, the subsequent elector must calculate
the recapture tax amount with respect to the dual consolidated loss subject
to the new domestic use agreement and include it, along with an identification
of the dual consolidated losses at issue and the original elector, on a statement
attached to its tax return. The subsequent elector calculates the recapture
tax amount based on a with and without calculation.
The recapture tax amount equals the excess (if any) of the income tax liability
of the subsequent elector for the taxable year of the subsequent triggering
event, over the income tax liability of the subsequent elector for such taxable
year computed by excluding the amount of recapture and related interest charge
with respect to the dual consolidated losses at issue.

In addition, the proposed regulations provide rules regarding tax assessment
and collection procedures. The proposed regulations provide that an assessment
identifying an income tax liability of the subsequent elector is considered
an assessment of the recapture tax amount where such amount is part of the
income tax liability being assessed and the recapture tax amount is reflected
in the statement attached to the subsequent elector’s tax return. The
recapture tax amount is considered to be properly assessed as an income tax
liability of the original elector, and each prior subsequent elector, if any,
on the same date the income tax liability of the subsequent elector was properly
assessed. This liability is joint and several.

The proposed regulations also provide procedures pursuant to which any
unpaid balance of the recapture tax amount may be collected from the original
elector and the prior subsequent elector, if any. Such amounts may be collected
from the original elector, and/or any prior subsequent elector, if each of
the following conditions is satisfied: (1) the Commissioner has properly assessed
the recapture amount; (2) the Commissioner has issued a notice and demand
for payment of the recapture tax amount to the subsequent elector; (3) the
subsequent elector has failed to pay all of the recapture tax amount by the
date specified in such notice and demand; and (4) the Commissioner has issued
a notice and demand for payment of the unpaid portion of the recapture tax
amount to the original elector and prior subsequent electors, if any. If
the subsequent elector’s income tax liability for a taxable period includes
a recapture amount, and if such income tax liability is satisfied in part
by payment, credit, or offset, such amount shall be allocated first to that
portion of the income tax liability that is not attributable to the recapture
tax amount, and then to that portion of the income tax liability that is attributable
to the recapture tax amount.

Finally, the proposed regulations contain rules regarding the refund
of an income tax liability that includes a recapture tax amount.

13. Character and source of recapture income

Section 1.1503-2(g)(2)(vii)(D) of the current regulations provides that
recapture income is treated as ordinary income having the same source and
falling within the same separate category under section 904 as the dual consolidated
loss being recaptured. The current regulations do not, however, provide an
explicit rule to identify the items that compose the dual consolidated loss.
As a result, it is unclear under the current regulations how to determine
the source and separate category of recapture income. In addition, the current
regulations do not explicitly state how the recapture income is treated for
purposes of the Code other than section 904.

The proposed regulations clarify that the character (to the extent consistent
with the recapture income being ordinary income in all cases) and source of
the recapture income is determined based on the character and source of a pro
rata portion of the deductions that were taken into account in
calculating the dual consolidated loss. As discussed above, the dual consolidated
loss is composed of a pro rata portion of all items of
deduction and loss that are taken into account in computing such dual consolidated
loss. Moreover, the proposed regulations clarify that the determination of
the character and source of such income is not limited to section 904, but
applies for all purposes of the Code (for example, section 856(c)(2) and (3)).

Under the proposed regulations, the character and source of losses and
deductions composing the dual consolidated loss should be identified during
the year in which they are incurred, rather than the year in which they are
ultimately used to offset income or gain. This approach attempts to simplify
the rules and make them more administrable, rather than providing comprehensive
stacking, ordering, and tracing rules that track the ultimate use of such
items, which would be complex.

14. Failure to comply with recapture provisions

Under the current regulations, if the taxpayer fails to comply with
the recapture provisions upon the occurrence of a triggering event, the dual
resident corporation or separate unit that incurred the dual consolidated
loss (or successor-in-interest) is not eligible to enter into a (g)(2)(i)
agreement with respect to any dual consolidated losses incurred in the five
taxable years beginning with the taxable year in which recapture is required.
The current regulations contain two exceptions to this rule that apply unless
the triggering event is an actual use of the dual consolidated loss. Under
the first exception, the rule does not apply if the failure to comply is due
to reasonable cause. Under the second exception, the rule does not apply
if the taxpayer unsuccessfully attempted to rebut the triggering event by
timely filing a rebuttal statement with its tax return.

This provision is intended to encourage taxpayers to carefully monitor
potential triggering events and properly comply with the recapture provisions
upon the occurrence of a triggering event.

The IRS and Treasury believe that the failure to comply penalty contained
in the current regulations often does not operate in a manner that encourages
compliance with the dual consolidated loss regulations. For example, if a
taxpayer sells a dual resident corporation to a third party that is treated
as a triggering event, but the taxpayer fails to comply with the recapture
rules, the rule contained in the current regulations prevents the purchaser
of the dual resident corporation from entering into a (g)(2)(i) agreement
with respect to dual consolidated losses of the dual resident corporation
for five years; it does not adversely affect the taxpayer that failed to properly
comply with the recapture provisions. As a result, the proposed regulations
do not include this penalty provision.

Although the proposed regulations do not retain this penalty provision,
the Commissioner may consider applying other applicable penalty provisions
in appropriate circumstances; for example, the Commissioner may consider applying
the accuracy-related penalty of section 6662. In addition, the IRS and Treasury
will continue to consider whether a penalty provision, similar to the one
contained in the current regulations, is appropriate, especially in cases
of repeated non-compliance.

F. Effective Date — §1.1503(d)-6

The proposed regulations are proposed to apply to dual consolidated
losses incurred in taxable years beginning after the date that these proposed
regulations are published as final regulations in the Federal
Register.

The IRS and Treasury request comments on the application of the regulations,
including comments as to whether the proposed regulations, when finalized,
should contain an election that would allow taxpayers to apply all or a portion
of the regulations retroactively. In addition, comments are requested as
to possible transition rules that may apply, including the application of
the proposed regulations, when finalized, to existing (g)(2)(i) agreements.

Effect on Other Documents

When these proposed regulations are adopted as final regulations, Rev.
Proc. 2000-42, 2000-2 C.B. 394, will be obsolete with respect to dual consolidated
losses incurred in taxable years beginning after the date that these proposed
regulations are published as final regulations in the Federal
Register.

Special Analyses

It has been determined that this notice of proposed rule making is not
a significant regulatory action as defined in Executive Order 12866. Therefore,
a regulatory assessment is not required. It is hereby certified that these
regulations will not have a significant economic impact on a substantial number
of small entities. This certification is based on the fact that these regulations
will primarily affect affiliated groups of corporations that also have a foreign
affiliate, which tend to be larger businesses. Moreover, the number of taxpayers
affected and the average burden are minimal. Therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to section 7805(f) of the Code, these regulations
will be submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on their impact on small business.

Comments and Public Hearing

A public hearing has been scheduled for September 7, 2005, at 10 a.m.,
in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue,
NW, Washington, DC. Because of access restrictions, visitors must enter at
the main entrance, located at 1111 Constitution Avenue, NW. All visitors
must present photo identification to enter the building. Because of access
restrictions, visitors will not be admitted beyond the immediate entrance
more than 30 minutes before the hearing starts. For information about having
your name placed on the building access list to attend hearing, see the “FOR
FURTHER INFORMATION CONTACT” portion of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments must submit written or electronic comments and
an outline of the topic to be discussed and time to be devoted to each topic
(preferably a signed original and eight (8) copies) by August 22, 2005. A
period of 10 minutes will be allotted to each person for making comments.
An agenda showing the scheduling of the speakers will be prepared after the
deadline for receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:

Authority: 26 USC 7805 * * *

§1.1503(d) also issued under 26 U.S.C. 953(d) and 26 U.S.C. 1502

Par. 2. In §1.1502-21, paragraph (c)(2)(v) is amended by removing
the language “§1.1503-2” and adding “§§1.1503(d)-1
through 1.1503(d)-6” in its place.

Par. 3. New §§1.1503(d)-0 through 1.1503(d)-6 are added to
read as follows:

§1.1503(d)-0 Table of contents.

This section lists the captions contained in §§1.1503(d)-1
through 1.1503(d)-6.

§1.1503(d)-1 Definitions and special rules for filings
under section 1503(d).

(ii) Original elector and prior subsequent electors not subject to recapture
or interest charge.

(iii) Recapture tax amount and required statement.

(A) In general.

(B) Recapture tax amount.

(iv) Tax assessment and collection procedures.

(A) In general.

(1) Subsequent elector.

(2) Original elector and prior subsequent electors.

(B) Collection from original elector and prior subsequent electors;
joint and several liability.

(C) Allocation of partial payments of tax.

(D) Refund.

(v) Definition of income tax liability.

(vi) Example.

(4) Computation of taxable income in year of recapture.

(i) Presumptive rule.

(ii) Rebuttal of presumptive rule.

(5) Character and source of recapture income.

(6) Reconstituted net operating loss.

(i) Termination of domestic use agreement and annual certifications.

(1) Rebuttal of triggering event.

(2) Exception to triggering event.

(3) Recapture of dual consolidated loss.

(4) Termination of ability for foreign use.

(i) In general.

(ii) Statement.

§1.1503(d)-5 Examples.

(a) In general.

(b) Presumed facts for examples.

(c) Examples.

§1.1503(d)-6 Effective date.

§1.1503(d)-1 Definitions and special rules for filings
under section 1503(d).

(a) In general. This section and §§1.1503(d)-2
through 1.1503(d)-6 provide general rules concerning the determination and
use of dual consolidated losses pursuant to section 1503(d). This section
provides definitions that apply for purposes of this section and §§1.1503(d)-2
through 1.1503(d)-6. This section also provides a reasonable cause exception
and a signature requirement for filings under this section and §§1.1503(d)-2
through 1.1503(d)-4.

(b) Definitions. The following definitions apply
for purposes of this section and §§1.1503(d)-2 through 1.1503(d)-6:

(1) Domestic corporation. The term domestic
corporation means an entity classified as a domestic corporation
under section 7701(a)(3) and (4) or otherwise treated as a domestic corporation
by the Internal Revenue Code, including, but not limited to, sections 269B,
953(d), and 1504(d). However, solely for purposes of Section 1503(d), the
term domestic corporation does not include an S corporation, as defined in
section 1361.

(2) Dual resident corporation. The term dual
resident corporation means a domestic corporation that is subject
to an income tax of a foreign country on its worldwide income or on a residence
basis. A corporation is taxed on a residence basis if it is taxed as a resident
under the laws of the foreign country. The term dual resident corporation also
means a foreign insurance company that makes an election to be treated as
a domestic corporation pursuant to section 953(d) and is treated as a member
of an affiliated group for purposes of chapter 6, even if such company is
not subject to an income tax of a foreign country on its worldwide income
or on a residence basis. See section 953(d)(3).

(3) Hybrid entity. The term hybrid entity means
an entity that is not taxable as an association for U.S. income tax purposes
but is subject to an income tax of a foreign country as a corporation (or
otherwise at the entity level) either on its worldwide income or on a residence
basis.

(4) Separate unit—(i) In general.
The term separate unit means either of the following
that is owned, directly or indirectly, by a domestic corporation—

(A) A foreign branch, as defined in §1.367(a)-6T(g) (foreign branch
separate unit); or

(B) An interest in a hybrid entity (hybrid entity separate unit).

(ii) Separate unit combination rule. If two or
more separate units (individual separate units) are owned, directly or indirectly,
by a single domestic corporation, and the losses of each individual separate
unit are made available to offset the income of the other individual separate
units under the income tax laws of a single foreign country, then such individual
separate units shall be treated as one separate unit (combined separate unit),
provided that—

(A) If the individual separate unit is a foreign branch separate unit,
it is located in such foreign country; and

(B) If the individual separate unit is a hybrid entity separate unit,
the hybrid entity (an interest in which is the hybrid entity separate unit)
is subject to an income tax of such foreign country either on its worldwide
income or on a residence basis. See §1.1503(d)-5(c) Example
1.

(iii) Indirectly. The term indirectly,
when used in reference to ownership of a separate unit, means ownership through
a separate unit, through an entity classified as a partnership under §§301.7701-1
through -3 of this chapter, or through a grantor trust (as defined in paragraph
(b)(15) of this section), regardless of whether the partnership or grantor
trust is a U.S. person.

(5) Dual consolidated loss. The term dual
consolidated loss means—

(i) In the case of a dual resident corporation, the net operating loss
(as defined in section 172(c) and the regulations thereunder) incurred in
a year in which the corporation is a dual resident corporation; and

(ii) In the case of a separate unit, the net loss attributable to, or
taken into account by, the separate unit under §1.1503(d)-3(b)(2).

(6) Subject to tax. For purposes of determining
whether a domestic corporation or hybrid entity is subject to an income tax
of a foreign country on its income, the fact that it has no actual income
tax liability to the foreign country for a particular taxable year shall not
be taken into account.

(7) Foreign country. The term foreign
country includes any possession of the United States.

(8) Consolidated group. The term consolidated
group means a consolidated group, as defined in §1.1502-1(h),
that includes either a dual resident corporation or a domestic owner.

(9) Domestic owner. The term domestic
owner means a domestic corporation that owns, directly or indirectly,
one or more separate units.

(10) Affiliated dual resident corporation and affiliated domestic
owner. The terms affiliated dual resident corporation and affiliated
domestic owner mean a dual resident corporation and a domestic
owner, respectively, that is a member of a consolidated group.

(i) A member of an affiliated group, without regard to the exceptions
contained in section 1504(b) (other than section 1504(b)(3)) relating to includible
corporations;

(ii) A domestic owner; or

(iii) A separate unit.

(13) Domestic use. A domestic use of
a dual consolidated loss shall be deemed to occur when the dual consolidated
loss is made available to offset, directly or indirectly, the taxable income
of any domestic affiliate of the dual resident corporation or separate unit
(that incurred the dual consolidated loss) in the taxable year in which the
dual consolidated loss is recognized, or in any other taxable year, regardless
of whether the dual consolidated loss offsets income under the income tax
laws of a foreign country and regardless of whether any income that the dual
consolidated loss may offset in the foreign country is, has been, or will
be subject to tax in the United States. A domestic use shall be deemed to
occur in the year the dual consolidated loss is included in the computation
of the taxable income of a consolidated group or an unaffiliated domestic
owner, even if no tax benefit results from such inclusion in that year. See
§1.1503(d)-5(c) Examples 2 through 5.

(14) Foreign use—(i) In general.
A foreign use of a dual consolidated loss shall be deemed
to occur when any portion of a loss or deduction taken into account in computing
the dual consolidated loss is made available under the income tax laws of
a foreign country to offset or reduce, directly or indirectly, any item that
is recognized as income or gain under such laws and that is considered under
U.S. tax principles to be an item of—

(A) A foreign corporation as defined in section 7701(a)(3) and (a)(5);
or

(B) A direct or indirect owner of an interest in a hybrid entity, provided
such interest is not a separate unit. See §1.1503(d)-5(c) Examples
6 through 11.

(ii) Available for use. A foreign use shall be
deemed to occur in the year in which any portion of a loss or deduction taken
into account in computing the dual consolidated loss is made available for
an offset described in paragraph (b)(14)(i) of this section, regardless of
whether it actually offsets or reduces any items of income or gain under the
income tax laws of the foreign country in such year and regardless of whether
any of the items that may be so offset or reduced are regarded as income under
U.S. tax principles.

(iii) Exceptions—(A) No election
to enable foreign use. Where the laws of a foreign country provide
an election that would enable a foreign use, a foreign use shall be considered
to occur only if the election is made.

(B) Presumed use where no foreign country rule for determining
use. If the losses or deductions composing the dual consolidated
loss are made available under the laws of a foreign country both to offset
income that would constitute a foreign use and to offset income that would
not constitute a foreign use, and the laws of the foreign country do not provide
applicable rules for determining which income is offset by the losses or deductions,
then for purposes of paragraph (b)(14) of this section, the losses or deductions
shall be deemed to be made available to offset income that does not constitute
a foreign use, to the extent of such income, before being considered to be
made available to offset the income that does constitute a foreign use. See
§1.1503(d)-5(c) Examples 12 and 14.

(C) No dilution of an interest in a separate unit—(1) General
rules—(i) Interest in a hybrid
entity partnership or hybrid entity grantor trust. Except as provided
in paragraph (b)(14)(iii)(C)(2) of this section, no foreign
use shall be considered to occur with respect to a dual consolidated loss
attributable to an interest in a hybrid entity partnership or a hybrid entity
grantor trust, solely because an item of deduction or loss taken into account
in computing such dual consolidated loss is made available, under the income
tax laws of a foreign country, to offset or reduce, directly or indirectly,
any item that is recognized as income or gain under such laws and, that is
considered under U.S. tax principles, to be an item of the direct or indirect
owner of an interest in such hybrid entity that is not a separate unit. See
§1.1503(d)-5(c) Examples 8 and 14 through 16.

(ii) Indirectly owned separate units.
Except as provided in paragraph (b)(14)(iii)(C)(2) of
this section, no foreign use shall be considered to occur with respect to
a dual consolidated loss attributable to or taken into account by a separate
unit owned indirectly through a partnership or grantor trust solely because
an item of deduction or loss taken into account in computing such dual consolidated
loss is made available, under the income tax laws of a foreign country, to
offset or reduce, directly or indirectly, any item that is recognized as income
or gain under such laws, and that is considered under U.S. tax principles,
to be an item of a direct or indirect owner of an interest in such partnership
or trust. See §1.1503(d)-5(c) Examples 17 and 18.

(iii) Combined separate unit.
This paragraph (b)(14)(iii)(C)(1)(iii)
applies to a dual consolidated loss attributable to or taken into account
by a combined separate unit that includes an individual separate unit to which
paragraph (b)(14)(iii)(C)(1)(i)
or (ii) of this section would apply, but for the application
of the separate unit combination rule provided under §1.1503(d)-1(b)(4)(ii).
Except as provided in paragraph (b)(14)(iii)(C)(2) of
this section, paragraph (b)(14)(iii)(C)(1)(i)
or (ii), as applicable, shall apply to the portion of
the dual consolidated loss of such combined separate unit that is attributable,
as provided under §1.1503(d)-3(b)(2)(vii)(B)(1),
to the individual separate unit (otherwise described in paragraph (b)(14)(iii)(C)(1)(i)
or (ii) of this section) that is a component of the combined
separate unit. See §1.1503(d)-5(c) Example 19.

(2) Exceptions—(i) Dilution
of an interest in a separate unit. Paragraph (b)(14)(iii)(C)(1)
of this section shall not apply with respect to any item of deduction or loss
that is taken into account in computing a dual consolidated loss attributable
to or taken into account by a separate unit if during any taxable year the
domestic owner’s percentage interest in such separate unit, as compared
to its interest in the separate unit as of the last day of the taxable year
in which such dual consolidated loss was incurred, is reduced as a result
of another person acquiring through sale, exchange, contribution or other
means, an interest in the partnership or grantor trust. The previous sentence
shall not apply, however, if the unaffiliated domestic owner or consolidated
group, as the case may be, demonstrates, to the satisfaction of the Commissioner,
that the other person that acquired the interest in the partnership or grantor
trust was a domestic corporation. Such demonstration must be made on a statement
that is attached to, and filed by the due date (including extensions) of,
its U.S. income tax return for the taxable year in which the ownership interest
of the domestic owner is reduced. See §1.1503(d)-5(c) Examples
14 through 16 and 19.

(ii) Consolidation and other prohibited
uses. Paragraph (b)(14)(iii)(C)(1) of this
section shall not apply if the availability described in such section does
not arise solely from the ownership in such partnership or grantor trust and
the allocation of the item of deduction or loss, or the offsetting by such
deduction or loss, of an item of income or gain of the partnership or trust.
For example, paragraph (b)(14)(iii)(C)(1) of this section
shall not apply in the case where the item of loss or deduction is made available
through a foreign consolidation regime. See §1.1503(d)-5(c) Examples
17 and 18.

(iv) Ordering rules for determining the foreign use of losses.
If the laws of a foreign country provide for the foreign use of a dual consolidated
loss, but do not provide applicable rules for determining the order in which
such losses are used in a taxable year, the following rules shall govern—

(A) Any net loss, or net income, that the dual resident corporation
or separate unit has in a taxable year shall first be used to offset net income,
or loss, recognized by its affiliates in the same taxable year before any
carryover of its losses is considered to be used to offset any income from
the taxable year;

(B) If under the laws of the foreign country the dual resident corporation
or separate unit has losses from different taxable years, it shall be deemed
to use first the losses from the earliest taxable year from which a loss may
be carried forward or back for foreign law purposes; and

(C) Where different losses or deductions (for example, capital losses
and ordinary losses) of a dual resident corporation or separate unit incurred
in the same taxable year are available for foreign use, the different losses
shall be deemed to be used on a pro rata basis. See §1.1503(d)-5(c) Example
13.

(v) Mirror legislation rule. Except to the extent
§1.1503(d)-4(b) applies, and other than for purposes of the consistency
rule under §1.1503(d)-4(d)(2), a foreign use shall be deemed to occur
if and when the income tax laws of a foreign country deny any opportunity
for the foreign use of the dual consolidated loss for any of the following
reasons—

(A) The loss is incurred by a dual resident corporation or separate
unit that is subject to income taxation by another country on its worldwide
income or on a residence basis;

(B) The loss may be available to offset income (other than income of
the dual resident corporation or separate unit) under the laws of another
country; or

(C) The deductibility of any portion of a loss or deduction taken into
account in computing the dual consolidated loss depends on whether such amount
is deductible under the laws of another country. See §1.1503(d)-5(c) Examples
20 through 23.

(15) Grantor trust. The term grantor
trust means a trust, any portion of which is treated as being owned
by the grantor or another person under subpart E of subchapter J of this chapter.

(c) Special rules for filings under section 1503(d)—(1) Reasonable
cause exception. If a person that is permitted or required to file
an election, agreement, statement, rebuttal, computation, or other information
under the provisions of this section or §§1.1503(d)-2 through 1.1503(d)-4
and that fails to make such filing in a timely manner, shall be considered
to have satisfied the timeliness requirement with respect to such filing if
the person is able to demonstrate, to the Director of Field operations having
jurisdiction of the taxpayer’s tax return for the taxable year, that
such failure was due to reasonable cause and not willful neglect. The previous
sentence shall only apply if, once the person becomes aware of the failure,
the person attaches all documents that should have been filed previously,
as well as a written statement setting forth the reasons for the failure to
timely comply, to an amended income tax return that amends the return to which
the documents should have been attached under the rules of this section or
§§1.1503(d)-2 through 1.1503(d)-4. In determining whether the taxpayer
has reasonable cause, the Director of Field Operations shall consider whether
the taxpayer acted reasonably and in good faith. Whether the taxpayer acted
reasonably and in good faith will be determined after considering all the
facts and circumstances. The Director of Field Operations shall notify the
person in writing within 120 days of the filing if it is determined that the
failure to comply was not due to reasonable cause, or if additional time will
be needed to make such determination.

(2) Signature requirement. When an election, agreement,
statement, rebuttal, computation, or other information is required under this
section or §§1.1503(d)-2 through 1.1503(d)-4 to be attached to and
filed by the due date (including extensions) of a U.S. tax return and signed
under penalties of perjury by the person who signs the return, the attachment
and filing of an unsigned copy is considered to satisfy such requirement,
provided the taxpayer retains the original in its records in the manner specified
by §1.6001-1(e).

§1.1503(d)-2 Operating rules.

(a) In general. This section provides operating
rules relating to dual consolidated losses, including a general rule prohibiting
the domestic use of a dual consolidated loss, a rule that eliminates a dual
consolidated loss following certain transactions, an anti-abuse rule for tainted
income, and rules for computing foreign tax credit limitations.

(b) Limitation on domestic use of a dual consolidated loss.
Except as provided in §1.1503(d)-4, the domestic use of a dual consolidated
loss is not permitted. See §1.1503(d)-5(c) Examples 2 through 4 and 5.

(c) Elimination of a dual consolidated loss after certain
transactions—(1) General rules—(i) Dual
resident corporation. Except as provided in paragraph (c)(2) of
this section, a dual consolidated loss of a dual resident corporation shall
not carry over to another corporation in a transaction described in section
381(a) and, as a result, shall be eliminated. See §1.1503(d)-5(c) Example
24.

(ii) Separate unit—(A) General
rule. Except as provided in paragraph (c)(2) of this section, a
dual consolidated loss of a separate unit shall not carry over as a result
of a transaction in which the separate unit ceases to be a separate unit of
its domestic owner (for example, as a result of a termination, dissolution,
liquidation, sale or other disposition of the separate unit) and, as a result,
shall be eliminated.

(B) Combined separate unit. This paragraph (c)(1)(ii)(B)
applies to an individual separate unit that is a component of a combined separate
unit that would, but for the separate unit combination rule, cease to be a
separate unit of its domestic owner. In such a case, and except as provided
in paragraph (c)(2) of this section, the portion of the dual consolidated
loss of the combined separate unit that is attributable to, or taken into
account by, as provided under §1.1503(d)-3(b)(2)(vii)(B)(1),
such individual separate unit shall not carry over and, as a result, shall
be eliminated.

(2) Exceptions—(i) Certain section
368(a)(1)(F) reorganizations. Paragraph (c)(1)(i) of this section
shall not apply to a reorganization described in section 368(a)(1)(F) in which
the resulting corporation is a domestic corporation.

(ii) Acquisition of a dual resident corporation by another
dual resident corporation. If a dual resident corporation transfers
its assets to another dual resident corporation in a transaction described
in section 381(a), and the transferee corporation is a resident of (or is
taxed on its worldwide income by) the same foreign country of which the transferor
was a resident (or was taxed on its worldwide income), then income generated
by the transferee may be offset by the carryover dual consolidated losses
of the transferor, subject to the limitations of §1.1503(d)-3(c) applied
as if the transferee generated the dual consolidated loss. Dual consolidated
losses of the transferor may not, however, be used to offset income of separate
units owned by the transferee because such separate units constitute domestic
affiliates of the transferee as provided under §1.1503(d)-1(b)(12)(iii).

(iii) Acquisition of a separate unit by a domestic corporation.
If a domestic owner transfers ownership of a separate unit to a domestic corporation
in a transaction described in section 381(a), and the transferee is a domestic
owner of the separate unit immediately following the transfer, then income
generated by the separate unit following the transfer may be offset by the
carryover dual consolidated losses of the separate unit, subject to the limitations
of §1.1503(d)-3(c) applied as if the separate unit of the transferee
generated the dual consolidated loss. In addition, if a domestic owner transfers
ownership of a separate unit to a domestic corporation in a transaction described
in section 381(a), the transferee is a domestic owner of the separate unit
immediately following the transfer, and the transferred separate unit is combined
with another separate unit of the transferee immediately after the transfer
as provided under §1.1503(d)-1(b)(4)(ii), then income generated by the
combined separate unit may be offset by the carryover dual consolidated losses
of the transferred separate unit, subject to the limitations of §1.1503(d)-3(c)
applied as if the combined separate unit of the transferee generated the dual
consolidated loss. See §1.1503(d)-5(c) Example 25.

(d) Special rule denying the use of a dual consolidated loss
to offset tainted income—(1) In general.
Dual consolidated losses incurred by a dual resident corporation shall not
be used to offset income it earns after it ceases to be a dual resident corporation
to the extent that such income is tainted income.

(2) Tainted income—(i) Definition.
For purposes of paragraph (d)(1) of this section, the term tainted
income means—

(A) Income or gain recognized on the sale or other disposition of tainted
assets; and

(B) Income derived as a result of holding tainted assets.

(ii) Income presumed to be derived from holding tainted assets.
In the absence of evidence establishing the actual amount of income that is
attributable to holding tainted assets, the portion of a corporation’s
income in a particular taxable year that is treated as tainted income derived
as a result of holding tainted assets shall be an amount equal to the corporation’s
taxable income for the year (other than income described in paragraph (d)(2)(i)(A)
of this section) multiplied by a fraction, the numerator of which is the fair
market value of all tainted assets acquired by the corporation (determined
at the time such assets were so acquired) and the denominator of which is
the fair market value of the total assets owned by the corporation at the
end of such taxable year. To establish the actual amount of income that is
attributable to holding tainted assets, documentation must be attached to,
and filed by the due date (including extensions) of, the domestic corporation’s
tax return or the consolidated tax return of an affiliated group of which
it is a member, as the case may be, for the taxable year in which the income
is generated. See §1.1503(d)-5(c) Example 26.

(3) Tainted assets defined. For purposes of paragraph
(d)(2) of this section, tainted assets are any assets acquired by a domestic
corporation in a nonrecognition transaction, as defined in section 7701(a)(45),
or any assets otherwise transferred to the corporation as a contribution to
capital, at any time during the three taxable years immediately preceding
the taxable year in which the corporation ceases to be a dual resident corporation
or at any time thereafter.

(4) Exceptions. Income derived from assets acquired
by a domestic corporation shall not be subject to the limitation described
in paragraph (d)(1) of this section, if—

(i) For the taxable year in which the assets were acquired, the corporation
did not have a dual consolidated loss (or a carryforward of a dual consolidated
loss to such year); or

(ii) The assets were acquired as replacement property in the ordinary
course of business.

(e) Computation of foreign tax credit limitation.
If a dual resident corporation or separate unit is subject to §1.1503(d)-3(c)
(addressing the effect of a dual consolidated loss on a domestic affiliate),
the consolidated group or unaffiliated domestic owner shall compute its foreign
tax credit limitation by applying the limitations of §1.1503(d)-3(c).
Thus, the items constituting the dual consolidated loss are not taken into
account until the year in which such items are absorbed.

§1.1503(d)-3 Special rules for accounting for dual consolidated
losses.

(a) In general. This section provides special rules
for determining the amount of income or loss of a dual resident corporation
or separate unit for purposes of section 1503(d). In addition, this section
provides rules for determining the effect of a dual consolidated loss on domestic
affiliates and for making special basis adjustments.

(b) Determination of amount of dual consolidated loss—(1) Affiliated
dual resident corporation. For purposes of determining whether
an affiliated dual resident corporation has a dual consolidated loss for the
taxable year, the dual resident corporation shall compute its taxable income
(or loss) in accordance with the rules set forth in the regulations under
section 1502 governing the computation of consolidated taxable income, taking
into account only the dual resident corporation’s items of income, gain,
deduction, and loss for the year. However, for purposes of this computation,
the following items shall not be taken into account—

(i) Any net capital loss of the dual resident corporation; and

(ii) Any carryover or carryback losses.

(2) Separate unit—(i) General rules.
Paragraph (b)(2) of this section applies for purposes of determining whether
a separate unit has a dual consolidated loss for the taxable year. The taxable
income (or loss) in U.S. dollars of a separate unit shall be computed as if
it were a separate domestic corporation and a dual resident corporation in
accordance with the provisions of paragraph (b)(1) of this section, using
only those existing items of income, gain, deduction, and loss (translated
into U.S. dollars) that are attributable to or taken into account by such
separate unit. Treating a separate unit as a separate domestic corporation
of the domestic owner under this paragraph shall not cause items of income,
gain, deduction and loss that are otherwise disregarded for U.S. Federal tax
purposes to be regarded for purposes of calculating a dual consolidated loss.
Paragraph (b)(2) of this section shall apply separately to each separate
unit and an item of income, gain, deduction, or loss shall not be considered
attributable to or taken into account by more than one separate unit. Items
of income, gain, deduction, and loss of one separate unit shall not offset
items of income, gain, deduction, and loss, or otherwise be taken into account
by, another separate unit for purposes of calculating a dual consolidated
loss. But see the separate unit combination rule in §1.1503(d)-1(b)(4)(ii).
See also §1.1503(d)-5(c) Example 27.

(ii) Foreign branch separate unit—(A) In
general. For purposes of determining the items of income, gain,
deduction (other than interest), and loss that are taken into account in determining
the taxable income or loss of a foreign branch separate unit, the principles
of section 864(c)(2) and (c)(4) as set forth in §1.864-4(c) and §1.864-6
shall apply. The principles apply without regard to limitations imposed on
the effectively connected treatment of income, gain or loss under the trade
or business safe harbors in section 864(b) and the limitations for treating
foreign source income as effectively connected under section 864(c)(4)(D).
For purposes of determining the interest expense that is taken into account
in determining the taxable income or loss of a foreign branch separate unit,
the principles of §1.882-5, subject to paragraph (b)(2)(ii)(B) of this
section, shall apply. When applying the principles of section 864(c) and
§1.882-5 (subject to paragraph (b)(2)(ii)(B) of this section), the domestic
corporation that owns, directly or indirectly, the foreign branch separate
unit shall be treated as a foreign corporation, the foreign branch separate
unit shall be treated as a trade or business within the United States, and
the other assets of the domestic corporation shall be treated as assets that
are not U.S. assets.

(B) Principles of §1.882-5. For purposes of
paragraph (b)(2)(ii)(A) of this section, the principles of §1.882-5 shall
be applied subject to the following—

(1) Except as otherwise provided in this section,
only the assets, liabilities and interest expense of the domestic owner shall
be taken into account in the §1.882-5 formula;

(2) Except as provided under paragraph (b)(2)(ii)(B)(3)
of this section, a taxpayer may use the alternative tax book value method
under §1.861-9T(i) for purposes of determining the value of its U.S.
assets pursuant to §1.882-5(b)(2) and its worldwide assets pursuant to
§1.882-5(c)(2);

(3) For purposes of determining the value of a
U.S. asset pursuant to §1.882-5(b)(2), and worldwide assets pursuant
to §1.882-5(c)(2), the taxpayer must use the same methodology under §1.861-9T(g)
(that is, tax book value, alternative tax book value, or fair market value)
that the taxpayer uses for purposes of allocating and apportioning interest
expense for the taxable year under section 864(e);

(4) Asset values shall be determined pursuant to
§1.861-9T(g)(2); and

(5) For purposes of determining the step-two U.S.
connected liabilities, the amounts of worldwide assets and liabilities under
§1.882-5(c)(2)(iii) and (iv), must be determined in accordance with U.S.
tax principles rather than substantially in accordance with U.S. tax principles.

(iii) Hybrid entity—(A) General
rule. The items of income, gain, deduction and loss attributable
to a hybrid entity are those items that are properly reflected on its books
and records under the principles of §1.988-4(b)(2), to the extent consistent
with U.S. tax principles. See §1.1503(d)-5(c) Example 28.

(B) Interest in a non-hybrid partnership and a non-hybrid
grantor trust. If a hybrid entity owns, directly or indirectly
(other than through a hybrid entity separate unit), an interest in either
a partnership that is not a hybrid entity or a grantor trust that is not a
hybrid entity, items of income, gain, deduction or loss that are properly
reflected on the books and records of such partnership or grantor trust (under
the principles of §1.988-4(b)(2), to the extent consistent with U.S.
tax principles), to the extent provided under paragraphs (b)(2)(v) or (b)(2)(vi)
of this section, respectively, shall be treated as being properly reflected
on the books and records of the hybrid entity for purposes of paragraph (b)(2)(iii)(A)
of this section. See §1.1503(d)-5(c) Example 30.

(iv) Interest in a disregarded hybrid entity.
Except as provided in paragraph (b)(2)(vii) of this section, for purposes
of determining the items of income, gain, deduction and loss that are attributable
to an interest in a hybrid entity that is disregarded as an entity separate
from its owner (for example, as a result of an election made pursuant to §301.7701-3(c)
of this chapter), those items described in paragraph (b)(2)(iii) of this section
shall be taken into account. See §1.1503(d)-5(c) Example 30.

(v) Items attributable to an interest in a hybrid entity partnership
and a separate unit owned indirectly through a partnership—(A)
This paragraph (b)(2)(v) applies for purposes of determining—

(1) The extent to which the items of income, gain,
deduction and loss attributable to a hybrid entity that is a partnership (as
provided in paragraph (b)(2)(iii) of this section) are attributable to an
interest in such hybrid entity partnership; and

(2) The extent to which items of income, gain,
deduction and loss of a separate unit that is owned indirectly through a partnership
are taken into account by a partner in such partnership.

(B) Items of income, gain, deduction and loss are taken into account
by the owner of such interest, or separate unit, to the extent such items
are includible in the owner’s distributive share of the partnership
income, gain, deduction and loss, as determined under the rules and principles
of subchapter K of this chapter. See §1.1503(d)-5(c) Example
30.

(vi) Items attributable to an interest in a hybrid entity
grantor trust and a separate unit owned indirectly through a grantor trust—(A)
This paragraph (b)(2)(vi) applies for purposes of determining—

(1) The extent to which items of income, gain,
deduction and loss attributable to a hybrid entity that is a grantor trust
(as provided in paragraph (b)(2)(iii) of this section) are attributable to
an interest in such grantor trust; and

(2) The extent to which the items of income, gain,
deduction and loss of a separate unit owned indirectly through a grantor trust
are taken into account by an owner of such grantor trust.

(B) Items of income, gain, deduction and loss are taken into account
to the extent such items are attributable to trust property that the holder
of the trust interest is treated as owning under the rules and principles
of subpart E of subchapter J of this chapter.

(vii) Special rules. The following special rules
shall apply for purposes of attributing items under paragraphs (b)(2)(i) through
(vi) of this section:

(A) Allocation of items between certain tiered separate units—(1)
When a hybrid entity owns, directly or indirectly (other than through a hybrid
entity separate unit), a foreign branch separate unit, for purposes of determining
items of income, gain, deduction and loss that are taken into account in determining
the taxable income or loss of such foreign branch separate unit, only items
of income, gain, deduction and loss that are attributable to the hybrid entity
as provided in paragraph (b)(2)(iii) of this section (and intervening entities,
if any, that are not themselves separate units) shall be taken into account.
Items of the hybrid entity (including assets and liabilities) are taken into
account for purposes of determining the taxable income or loss of the foreign
branch separate unit pursuant to paragraph (b)(2)(ii) of this section. See
§1.1503(d)-5(c) Example 30.

(2) For purposes of determining items of income,
gain, deduction and loss that are attributable to an interest in the hybrid
entity described in paragraph (b)(2)(vii)(A)(1) of this
section, the items attributable to the hybrid entity in paragraph (b)(2)(iii)
of this section shall not be taken into account to the extent they are also
taken into account in determining, under the rules of paragraph (b)(2)(ii)
of this section, the taxable income or loss of a foreign branch separate unit
that is owned, directly or indirectly (other than through a hybrid entity
separate unit), by the hybrid entity separate unit. See §1.1503(d)-5(c) Example
30.

(B) Combined separate unit. If two or more separate
units defined in §1.1503(d)-1(b)(4)(i) are treated as one combined separate
unit pursuant to §1.1503(d)-1(b)(4)(ii), the items of income, gain, deduction
and loss that are attributable to or taken into account in determining the
taxable income of the combined separate unit shall be determined as follows—

(1) Items of income, gain, deduction and loss are
first attributed to, or taken into account by, each individual separate unit,
as defined in §1.1503(d)-1(b)(4)(i) without regard to §1.1503(d)-1(b)(4)(ii),
pursuant to the rules of paragraph (b)(2) of this section; and

(2) The combined separate unit then takes into
account all of the items of income, gain, deduction and loss attributable
to, or taken into account by, the individual separate units pursuant to paragraph
(b)(2)(vii)(B)(1) of this section. See §1.1503(d)-5(c) Example
30.

(C) Gain or loss on the direct or indirect disposition of
a separate unit. For purposes of calculating a dual consolidated
loss of a separate unit, items of income or gain (including loss recapture
income or gain under section 367(a)(3)(C) or 904(f)(3)), deduction and loss
recognized on the sale, exchange or other disposition of a separate unit (or
an interest in a partnership or grantor trust that owns, directly or indirectly,
a separate unit), are attributable to or taken into account by the separate
unit to the extent of the gain or loss that would have been recognized had
such separate unit sold all its assets in a taxable exchange, immediately
before the disposition of the separate unit, for an amount equal to their
fair market value. If, as a result of the sale, exchange or other disposition
of a separate unit (or interest in a partnership or grantor trust) more than
one separate unit is, directly or indirectly, disposed of, items of income,
gain, deduction, and loss recognized on such disposition are attributable
to or taken into account by each such separate unit (under the rules of this
paragraph (b)(2)(vii)(C)) based on the gain or loss that would have been recognized
by each separate unit if it had sold all of its assets in a taxable exchange,
immediately before the disposition of the separate unit, for an amount equal
to their fair market value. See §1.1503(d)-5(c) Examples 31 through 34.

(D) Income inclusion on stock. Any amount included
in income of a U.S. person arising from ownership of stock in a foreign corporation
(for example, under section 951) through a separate unit shall be taken into
account for purposes of calculating the dual consolidated loss of the separate
unit if an actual dividend from such foreign corporation would have been so
taken into account. See §1.1503(d)-5(c) Example 29.

(3) Foreign tax treatment disregarded. The fact
that a particular item taken into account in computing a dual resident corporation’s
net operating loss, or a separate unit’s loss, is not taken into account
in computing income subject to a foreign country’s income tax shall
not cause such item to be excluded from the calculation of the dual consolidated
loss.

(4) Items generated or incurred while a dual resident corporation
or a separate unit. For purposes of determining the amount of the
dual consolidated loss of a dual resident corporation or a separate unit for
the taxable year, only the items of income, gain, deduction and loss generated
or incurred during the period the dual resident corporation or separate unit
qualified as such shall be taken into account. The allocation of items to
such period shall be made under the principles of §1.1502-76(b).

(c) Effect of a dual consolidated loss on a domestic affiliate.
For any taxable year in which a dual resident corporation or separate unit
has a dual consolidated loss to which §1.1503(d)-2(b) applies, the following
rules shall apply:

(1) Dual resident corporation. If the dual resident
corporation is a member of a consolidated group, the group shall compute its
consolidated taxable income (or loss) by taking into account the dual resident
corporation’s items of gross income, gain, deduction, or loss taken
into account in computing the dual consolidated loss, other than those items
of deduction and loss that compose the dual resident corporation’s dual
consolidated loss. The dual consolidated loss shall be treated as composed
of a pro rata portion of each item of deduction and loss
of the dual resident corporation taken into account in calculating the dual
consolidated loss. The dual consolidated loss is subject to the limitations
on its use contained in paragraph (c)(3) of this section and, subject to such
limitation, may be carried over or back for use in other taxable years as
a separate net operating loss carryover or carryback of the dual resident
corporation arising in the year incurred.

(2) Separate unit. The unaffiliated domestic owner
of a separate unit, or the consolidated group of an affiliated domestic owner
of a separate unit, shall compute its taxable income (or loss) by taking into
account the separate unit’s items of gross income, gain, deduction and
loss taken into account in computing the dual consolidated loss, other than
those items of deduction and loss that compose the separate unit’s dual
consolidated loss. The dual consolidated loss shall be treated as composed
of a pro rata portion of each item of deduction and loss
of the separate unit taken into account in calculating the dual consolidated
loss. The dual consolidated loss is subject to the limitations contained in
paragraph (c)(3) of this section as if the separate unit that generated the
dual consolidated loss were a separate domestic corporation that filed a consolidated
return with its unaffiliated domestic owner or with the consolidated group
of its affiliated domestic owner. Subject to such limitation, the dual consolidated
loss may be carried over or back for use in other taxable years as a separate
net operating loss carryover or carryback of the separate unit arising in
the year incurred.

(3) SRLY limitation. The dual consolidated loss
shall be treated as a loss incurred by the dual resident corporation or separate
unit in a separate return limitation year and shall be subject to all of the
limitations of §1.1502-21(c) (SRLY limitation), subject to the following—

(i) Notwithstanding §1.1502-1(f)(2)(i), the SRLY limitation is
applied to any dual consolidated loss of a common parent;

(ii) The SRLY limitation is applied without regard to §1.1502-21(c)(2)
(SRLY subgroup limitation) and 1.1502-21(g) (overlap with section 382);

(iii) For purposes of calculating the general SRLY limitation under
§1.1502-21(c)(1)(i), the calculation of aggregate consolidated taxable
income shall only include items of income, gain, deduction or loss generated—

(A) In the case of a dual resident corporation or hybrid entity separate
unit, in years in which the dual resident corporation or hybrid entity (whose
interest constitutes the separate unit) is resident (or is taxed on its worldwide
income) in the same foreign country in which it was resident (or was taxed
on its worldwide income) during the year in which the dual consolidated loss
was generated; and

(B) In the case of a foreign branch separate unit, items of income,
gain, deduction or loss generated in years in which the foreign branch qualified
as a separate unit; and

(iv) For purposes of calculating the general SRLY limitation under §1.1502-21(c)(1)(i),
the calculation of aggregate consolidated taxable income shall not include
any amount included in income pursuant to §1.1503(d)-4(h) (relating to
the recapture of a dual consolidated loss).

(4) Items of a dual consolidated loss used in other taxable
years. A pro rata portion of each item of
deduction or loss that composes the dual consolidated loss shall be considered
to be used when the dual consolidated loss is used in other taxable years.
See §1.1503(d)-5(c) Example 35.

(d) Special basis adjustments—(1) Affiliated
dual resident corporation or affiliated domestic owner. If a dual
resident corporation or domestic owner is a member of a consolidated group,
each other member owning stock in the dual resident corporation or domestic
owner shall adjust the basis of the stock in accordance with the principles
of §1.1502-32(b), subject to the following:

(i) Dual consolidated loss subject to domestic use limitation.
There shall be a negative adjustment under §1.1502-32(b)(2) for any amount
of a dual consolidated loss of the dual resident corporation (or, in the case
of a domestic owner, of separate units of such domestic owner) that is not
absorbed as a result of the application of §§1.1503(d)-2(b) and
3(c).

(ii) Dual consolidated loss absorbed in carryover or carryback
year. There shall be no negative adjustment under §1.1502-32(b)(2)
for the amount of a dual consolidated loss of the dual resident corporation
(or, in the case of a domestic owner, of separate units of such domestic owner)
subject to §§1.1503(d)-2(b) and 1.1503(d)-3(c) that is absorbed
in a carryover or carryback taxable year.

(iii) Recapture income. There shall be no positive
adjustment under §1.1502-32(b)(2) for any amount included in income by
the dual resident corporation or domestic owner pursuant to §1.1503(d)-4(h).

(2) Interests in hybrid entities that are partnerships or
interests in partnerships through which a separate unit is owned indirectly—(i) Scope.
This paragraph (d)(2) applies for purposes of determining the adjusted basis
of an interest in:

(A) A hybrid entity that is a partnership; and

(B) A partnership through which a domestic owner indirectly owns a separate
unit.

(ii) Determination of basis of partner’s interest.
The adjusted basis of an interest in a hybrid entity that is a partnership,
or a partnership through which a domestic owner indirectly owns a separate
unit, shall be adjusted in accordance with section 705 of this chapter, except
as otherwise provided in this paragraph (d)(2)(ii).

(A) Dual consolidated loss subject to domestic use limitation.
The adjusted basis shall be decreased for any amount of the dual consolidated
loss that is not absorbed as a result of the application of §§1.1503(d)-2(b)
and 1.1503(d)-3(c).

(B) Dual consolidated loss absorbed in carryover or carryback
year. The adjusted basis shall not be decreased for the amount
of a dual consolidated loss subject to §§1.1503(d)-2(b) and 1.1503(d)-3(c)
that is absorbed in a carryover or carryback taxable year.

(C) Recapture income. The adjusted basis shall
not be increased for any amount included in income pursuant to §1.1503(d)-4(h).

(3) Examples. See §1.1503(d)-5(c) Examples
36 and 37.

§1.1503(d)-4 Exceptions to the domestic use limitation
rule.

(a) In general. This section provides certain exceptions
to the domestic use limitation rule of §1.1503(d)-2(b).

(b) Elective agreement in place between the United States
and a foreign country. The domestic use limitation rule of §1.1503(d)-2(b)
shall not apply to a dual consolidated loss to the extent the consolidated
group, unaffiliated dual resident corporation, or unaffiliated domestic owner,
as the case may be, elects to deduct the loss in the United States pursuant
to an agreement entered into between the United States and a foreign country
that puts into place an elective procedure through which losses offset income
in only one country.

(c) No possibility of foreign use—(1) In
general. The domestic use limitation rule of §1.1503(d)-2(b)
shall not apply to a dual consolidated loss if the consolidated group, unaffiliated
dual resident corporation, or unaffiliated domestic owner, as the case may
be—

(i) Demonstrates, to the satisfaction of the Commissioner, that no foreign
use of the dual consolidated loss occurred in the year in which it was incurred,
and no such use can occur in any other year by any means; and

(ii) Prepares a statement described in paragraph (c)(2) of this section
that is attached to, and filed by the due date (including extensions) of,
its U.S. income tax return for the taxable year in which the dual consolidated
loss is incurred. See §1.1503(d)-5(c) Examples 38 through 40.

(2) Statement. The statement described in this
section must be signed under penalties of perjury by the person who signs
the tax return. The statement must be labeled No Possibility of Foreign Use
of Dual Consolidated Loss Statement at the top of the page and must include
the following items, in paragraphs labeled to correspond with the items set
forth in paragraphs (c)(2)(i) through (iv) of this section:

(i) A statement that the document is submitted under the provisions
of §1.1503(d)-4(c);

(ii) The name, address, tax identification number, and place and date
of incorporation of the dual resident corporation, and the country or countries
that tax the dual resident corporation on its worldwide income or on a residence
basis, or, in the case of a separate unit, identification of the separate
unit, including the name under which it conducts business, its principal activity,
and the country in which its principal place of business is located;

(iii) A statement of the amount of the dual consolidated loss at issue;
and

(iv) An analysis, in reasonable detail and specificity, supported with
official or certified English translations of the relevant provisions of foreign
law, of the treatment of the losses and deductions composing the dual consolidated
loss under the laws of the foreign jurisdiction and the reasons supporting
the conclusion that no foreign use of the dual consolidated loss occurred
in the year in which it was incurred, and no such use can occur in any other
year by any means.

(d) Domestic use election—(1) In
general. The domestic use limitation rule of §1.1503(d)-2(b)
shall not apply to a dual consolidated loss if an election to be bound by
the provisions of this paragraph (d) of this section (domestic use election)
is made by the consolidated group, unaffiliated dual resident corporation,
or unaffiliated domestic owner, as the case may be (elector). In order to
elect relief under this paragraph (d) of this section, an agreement described
in this paragraph (d)(1) of this section (domestic use agreement) must be
attached to, and filed by the due date (including extensions) of, the U.S.
income tax return of the elector for the taxable year in which the dual consolidated
loss is incurred. The domestic use agreement must be signed under penalties
of perjury by the person who signs the return. If dual consolidated losses
of more than one dual resident corporation or separate unit are subject to
the rules of this paragraph (d) which requires the filing of domestic use
agreements by the same elector, the agreements may be combined in a single
document, but the information required by paragraphs (d)(1)(ii) and (iv) of
this section must be provided separately with respect to each dual consolidated
loss. The domestic use agreement must be labeled Domestic Use Election and
Agreement at the top of the page and must include the following items, in
paragraphs labeled to correspond with the following:

(i) A statement that the document submitted is an election and an agreement
under the provisions of §1.1503(d)-4(d);

(ii) The name, address, tax identification number, and place and date
of incorporation of the dual resident corporation, and the country or countries
that tax the dual resident corporation on its worldwide income or on a residence
basis, or, in the case of a separate unit, identification of the separate
unit, including the name under which it conducts business, its principal activity,
and the country in which its principal place of business is located;

(iii) An agreement by the elector to comply with all of the provisions
of paragraphs (d) through (h) of this section, as applicable;

(iv) A statement of the amount of the dual consolidated loss covered
by the agreement;

(v) A certification that there has not been, and will not be, a foreign
use of the dual consolidated loss in any taxable year up to and including
the seventh taxable year following the year in which the dual consolidated
loss that is the subject of the agreement filed under paragraph (d) of this
section was incurred (certification period);

(vi) A certification that arrangements have been made to ensure that
there will be no foreign use of the dual consolidated loss during the certification
period, and that the elector will be informed of any such foreign use of the
dual consolidated loss during such period;

(vii) If applicable, a notification that an excepted triggering event
under paragraph (f)(2)(i) of this section has occurred with respect to the
dual consolidated loss within the taxable year covered by the elector’s
tax return and providing the name, taxpayer identification number, and address
of the subsequent elector (within the meaning of paragraph (f)(2)(iii)(A)
of this section) that will be filing future certifications with respect to
such dual consolidated loss.

(2) Consistency rule. If under the laws of a particular
foreign country there is a foreign use of a dual consolidated loss of a dual
resident corporation or separate unit that is subject to a domestic use agreement
(but not a new domestic use agreement, defined in paragraph (f)(2)(iii)(A)
of this paragraph), then a foreign use shall be deemed to occur for the following
other dual consolidated losses (if any), but only if the income tax laws of
the foreign country permit a foreign use of such other dual consolidated losses
in the same taxable year—

(i) Any dual consolidated loss of a dual resident corporation that is
a member of the same consolidated group of which the first dual resident corporation
or domestic owner is a member, if any deduction or loss taken into account
in computing such dual consolidated loss is recognized under the income tax
laws of such foreign country in the same taxable year; and

(ii) Any dual consolidated loss of a separate unit that is owned directly
or indirectly by the same domestic owner that owns the first separate unit,
or that is owned directly or indirectly by any member of the same consolidated
group of which the first dual resident corporation or domestic owner is a
member, if any deduction or loss taken into account in computing such dual
consolidated loss is recognized under the income tax laws of such foreign
country in the same taxable year. See §1.1503(d)-5(c) Examples
41 and 42.

(3) Restrictions on domestic use election—(i) Triggering
event in year of dual consolidated loss. Except as otherwise provided
in this section, if an event described in paragraphs (e)(1)(i) through (vii)
of this section occurs during the year in which a dual resident corporation
or separate unit incurs a dual consolidated loss (including a dual consolidated
loss resulting, in whole or in part, from the occurrence of the triggering
event itself), the consolidated group, unaffiliated dual resident corporation,
or unaffiliated domestic owner, as the case may be, may not make a domestic
use election with respect to the dual consolidated loss and such loss therefore
is subject to the domestic use limitation rule of §1.1503(d)-2(b). See
§1.1503(d)-5(c) Example 32. See also §1.1503(d)-2(c)
for rules that eliminate a dual consolidated loss after certain transactions.

(ii) Losses of a foreign insurance company treated as a domestic
corporation. A foreign insurance company that has elected to be
treated as a domestic corporation pursuant to section 953(d) may not make
a domestic use election. See section 953(d)(3).

(e) Triggering events requiring the recapture of a dual consolidated
loss—(1) Events. The elector must agree
that, except as provided under paragraphs (e)(2) and (f) of this section,
if there is a triggering event described in this paragraph (e) during the
certification period, the elector will recapture and report as income the
amount of the dual consolidated loss as provided in paragraph (h) of this
section on its tax return for the taxable year in which the triggering event
occurs (or, when the triggering event is a foreign use of the dual consolidated
loss, the taxable year that includes the last day of the foreign tax year
during which such use occurs). In addition, the elector must pay any applicable
interest charge required by paragraph (h) of this section. For purposes of
this section, except as provided under paragraphs (e)(2) and (f) of this section,
any of the following events shall constitute a triggering event:

(i) Foreign use. A foreign use of the dual consolidated
loss (including a deemed foreign use pursuant to the mirror legislation rule
set forth in §1.1503(d)-1(b)(13)(ii)(D) or the consistency rule set forth
in paragraph (d)(2) of this section).

(ii) Disaffiliation. An affiliated dual resident
corporation or affiliated domestic owner ceases to be a member of the consolidated
group that made the domestic use election. For purposes of this paragraph
(e)(1)(ii), a dual resident corporation or domestic owner shall be considered
to cease to be a member of the consolidated group if it is no longer a member
of the group within the meaning of §1.1502-1(b), or if the group ceases
to exist (for example, when the group no longer files a consolidated return).
See §1.1503(d)-5(c) Example 47.

(iii) Affiliation. An unaffiliated dual resident
corporation or unaffiliated domestic owner becomes a member of a consolidated
group. Any consequences resulting from this triggering event (for example,
recapture of a dual consolidated loss) shall be taken into account in the
tax return of the unaffiliated dual resident corporation or unaffiliated domestic
owner for the taxable year that ends immediately before the taxable year in
which the unaffiliated dual resident corporation or unaffiliated domestic
owner becomes a member of the consolidated group.

(iv) Transfer of assets. Fifty percent or more
of the dual resident corporation’s or separate unit’s gross assets
(measured by the fair market value of the assets at the time of such transfer
(or for multiple transactions, at the time of the first transfer)) are sold
or otherwise disposed of in either a single transaction or a series of transactions
within a twelve-month period. For purposes of this paragraph, the interest
in a separate unit and the shares of a dual resident corporation shall not
be treated as assets of a dual resident corporation or a separate unit.

(v) Transfer of an interest in a separate unit.
Fifty percent or more of the interest in a separate unit (measured by voting
power or value) owned directly or indirectly by the domestic owner on the
last day of the taxable year in which the dual consolidated loss was incurred
is sold or otherwise disposed of either in a single transaction or a series
of transactions within a twelve-month period.

(vi) Conversion to a foreign corporation. An unaffiliated
dual resident corporation, unaffiliated domestic owner, or hybrid entity an
interest in which is a separate unit, becomes a foreign corporation by means
of a transaction (for example, a reorganization, or an election to be classified
as a corporation under §301.7701-3(c) of this chapter) that, for foreign
tax purposes, is not treated as involving a transfer of assets (and carryover
of losses) to a new entity.

(vii) Conversion to an S corporation. An unaffiliated
dual resident corporation or unaffiliated domestic owner elects to be an S
corporation pursuant to section 1362(a).

(viii) Failure to certify. The elector fails to
file a certification required under paragraph (g) of this section.

(2) Rebuttal. An event described in paragraphs
(e)(1)(ii) through (viii) of this section shall not constitute a triggering
event if the elector demonstrates, to the satisfaction of the Commissioner,
that there can be no foreign use of the dual consolidated loss at any time
during the remaining certification period. The elector must prepare a statement,
labeled Rebuttal of Triggering Event at the top of the page, that indicates
that it is submitted under the provisions of this section §1.1503(d)-4(e)(2).
The statement must set forth an analysis, in reasonable detail and specificity,
supported with official or certified English translations of the relevant
provisions of foreign law, of the treatment of the losses and deductions composing
the dual consolidated loss under the facts of the event in question. The
statement must be attached to, and filed by the due date (including extensions)
of, the elector’s income tax return for the taxable year in which the
presumed triggering event occurs. See §1.1503(d)-5(c) Examples
43 through 45.

(f) Exceptions—(1) Acquisition
by a member of the consolidated group. The following events shall
not constitute triggering events, requiring the recapture of the dual consolidated
loss under paragraph (h) of this section—

(i) An affiliated dual resident corporation or affiliated domestic owner
ceases to be a member of a consolidated group solely by reason of a transaction
in which a member of the same consolidated group succeeds to the tax attributes
of the dual resident corporation or domestic owner under the provisions of
section 381.

(ii) Assets of an affiliated dual resident corporation or assets of
a separate unit owned by an affiliated domestic owner are acquired in any
other transaction by—

(A) One or more members of its consolidated group; or

(B) A partnership, a grantor trust, or a hybrid entity, but only if
100 percent of such entity’s interests are owned, directly or indirectly,
by such affiliated dual resident corporation or affiliated domestic owner,
as the case may be, or by members of its consolidated group.

(iii) Assets of a separate unit are acquired in any other transaction
by its domestic owner or by a hybrid entity or grantor trust, but only if
100 percent of such entity’s interest is owned by the domestic owner.

(iv) The interest of a hybrid entity separate unit, or an indirectly
owned separate unit, owned by an affiliated domestic owner, is transferred
to—

(A) A member of its consolidated group; or

(B) A partnership, a grantor trust, or a hybrid entity, but only if
100 percent of such entity’s interests are owned, directly or indirectly,
by such affiliated domestic owner, or by members of its consolidated group.

(2) Acquisition by an unaffiliated domestic corporation or
a new consolidated group—(i) Subsequent elector
events. If all the requirements of paragraph (f)(2)(iii) of this
section are met, the following events shall not constitute triggering events
requiring the recapture of the dual consolidated loss under paragraph (h)
of this section—

(A) An affiliated dual resident corporation or affiliated domestic owner
becomes an unaffiliated domestic corporation or a member of a new consolidated
group (other than in a transaction described in paragraph (f)(2)(ii)(B) of
this section);

(B) Assets of a dual resident corporation or a separate unit are acquired
by—

(1) An unaffiliated domestic corporation;

(2) One or more members of a new consolidated group;
or

(3) A partnership, a grantor trust, or a hybrid
entity, but only if 100 percent of such entity’s interests are owned,
directly or indirectly, by members of a new consolidated group.

(C) The interest of a hybrid entity separate unit, or an indirectly
owned separate unit, owned by a domestic owner is transferred to—

(1) An unaffiliated domestic corporation;

(2) One or more members of a new consolidated group;
or

(3) A partnership, a grantor trust, or a hybrid
entity, but only if 100 percent of such entity’s interests is owned,
directly or indirectly, by members of a new consolidated group.

(ii) Non-subsequent elector events. If the requirements
of paragraph (f)(2)(iii)(A) of this section are met, the following events
also shall not constitute triggering events requiring the recapture of the
dual consolidated loss under paragraph (h) of this section—

(A) An unaffiliated dual resident corporation or unaffiliated domestic
owner becomes a member of a consolidated group; or

(B) A consolidated group that filed a domestic use agreement ceases
to exist as a result of a transaction described in §1.1502-13(j)(5)(i)
(other than a transaction in which any member of the terminating group, or
the successor-in-interest of such member, is not a member of the surviving
group immediately after the terminating group ceases to exist). See §1.1503(d)-5(c) Example
46.

(iii) Requirements—(A) New domestic
use agreement. The unaffiliated domestic corporation or new consolidated
group (subsequent elector) must file an agreement described in paragraph (d)(1)
of this section (new domestic use agreement). The new domestic use agreement
must be labeled New Domestic Use Agreement at the top of the page, and must
be attached to and filed by the due date (including extensions) of, the subsequent
elector’s income tax return for the taxable year in which the event
described in paragraph (f)(2)(i) or (f)(2)(ii) of this section occurs. The
new domestic use agreement must be signed under penalties of perjury by the
person who signs the return and must include the following items—

(1) A statement that the document submitted is
an election and agreement under the provisions of §1.1503(d)-4(f)(2);

(2) An agreement to assume the same obligations
with respect to the dual consolidated loss as the corporation or consolidated
group that filed the original domestic use agreement (original elector) with
respect to that loss;

(3) An agreement to treat any potential recapture
amount under paragraph (h) of this section with respect to the dual consolidated
loss as unrealized built-in gain for purposes of section 384(a), subject to
any applicable exceptions thereunder;

(4) An agreement to be subject to the successor
elector rules as provided in paragraph (h)(3) of this section; and

(5) The name, U.S. taxpayer identification number,
and address of the original elector and prior subsequent electors with respect
to the dual consolidated losses, if any.

(B) Statement filed by original elector. The original
elector must file a statement that is attached to and filed by the due date
(including extensions) of its income tax return for the taxable year in which
the event described in paragraph (f)(2)(i) of this section occurs. The statement
must be labeled Original Elector Statement at the top of the page, must be
signed under penalties of perjury by the person who signs the tax return,
and must include the following items—

(1) A statement that the document submitted is
an election and agreement under the provisions of §1.1503(d)-4(f)(2);

(2) An agreement to be subject to the successor
elector rules as provided in paragraph (h)(3) of this section; and

(3) The name, U.S. taxpayer identification number,
and address of the subsequent elector.

(3) Subsequent triggering events. Any triggering
event described in paragraph (e) of this section that occurs subsequent to
one of the transactions described in paragraph (f)(1) or (2) of this section,
and that itself does not fall within the exceptions provided in paragraph
(f)(1) or (2) of this section, shall require recapture under paragraph (h)
of this section.

(g) Annual certification reporting requirement.
Except as provided in paragraph (i) of this section, the elector must file
a certification, labeled Certification of Dual Consolidated Loss at the top
of the page, that is attached to, and filed by the due date (including extensions)
of, its income tax return for each taxable year during the certification period.
The certification must certify that there has been no foreign use of such
dual consolidated loss. The certification must identify the dual consolidated
loss to which it pertains by setting forth the elector’s year in which
the loss was incurred and the amount of such loss. In addition, the certification
must warrant that arrangements have been made to ensure that there will be
no foreign use of the dual consolidated loss and that the elector will be
informed of any such foreign use. If dual consolidated losses of more than
one taxable year are subject to the rules of this paragraph (g) of this section,
the certification for those years may be combined in a single document but
each dual consolidated loss must be separately identified.

(h) Recapture of dual consolidated loss and interest charge—(1) Presumptive
rules—(i) Amount of recapture. Except
as otherwise provided in this section, upon the occurrence of a triggering
event described in paragraph (e)(1) of this section that falls outside the
exceptions provided in paragraph (f)(1) or (2) of this section, the dual resident
corporation or separate unit shall recapture, and the elector shall report,
as gross income the total amount of the dual consolidated loss to which the
triggering event applies on its income tax return for the taxable year in
which the triggering event occurs (or, when the triggering event is a foreign
use of the dual consolidated loss, the taxable year that includes the last
day of the foreign tax year during which such foreign use occurs).

(ii) Interest charge. In connection with the recapture,
the elector shall pay an interest charge. Except as otherwise provided in
this section, such interest shall be determined under the rules of section
6601(a) as if the additional tax owed as a result of the recapture had accrued
and been due and owing for the taxable year in which the losses or deductions
taken into account in computing the dual consolidated loss gave rise to a
tax benefit for U.S. income tax purposes. For purposes of this paragraph
(h)(1)(ii), a tax benefit shall be considered to have arisen in a taxable
year in which such losses or deductions reduced U.S. taxable income. See
§1.1503(d)-5(c) Example 51.

(2) Reduction of presumptive recapture amount and presumptive
interest charge —(i) Amount of recapture.
The amount of dual consolidated loss that must be recaptured under paragraph
(h) of this section may be reduced if the elector demonstrates, to the satisfaction
of the Commissioner, the offset permitted by this paragraph (h)(2)(i). The
reduction in the amount of recapture is the amount by which the dual consolidated
loss would have offset other taxable income reported on a timely filed U.S.
income tax return for any taxable year up to and including the taxable year
of the triggering event if such loss had been subject to the restrictions
of §1.1503(d)-2(b) (and therefore subject to the limitation under §1.1503(d)-3(c)(3)).
In the case of a separate unit, the prior sentence is applied as if the separate
unit were a separate domestic corporation that filed a consolidated return
with its unaffiliated domestic owner or with the consolidated group of its
affiliated domestic owner. For purposes of determining the reduction in the
amount of recapture pursuant to this paragraph, the rules under §1.1503(d)-3(b)
shall apply. Any reduction to recapture pursuant to this paragraph that is
attributable to income generated in taxable years prior to the year in which
the dual consolidated loss was generated, subject to the restrictions of §1.1503(d)-2(b)
(and therefore subject to the limitation under §1.1503(d)-3(c)(3)), shall
be permitted only if the elector demonstrates to the satisfaction of the Commissioner
that the dual resident corporation or separate unit, as the case may be, qualified
as such (with respect to the same foreign country in which the dual consolidated
loss was generated) in the taxable years such income was generated. An elector
utilizing this rebuttal rule must prepare a separate accounting showing that
the income for each year that offsets the dual resident corporation or separate
unit’s recapture amount is attributable only to the dual resident corporation
or separate unit. The separate accounting must be signed under penalties
of perjury by the person who signs the elector’s tax return, must be
labeled Reduction of Recapture Amount at the top of the page, and must indicate
that it is submitted under the provisions of paragraph (h)(2)(i) of this section.
The accounting must be attached to, and filed by the due date (including
extensions) of, the elector’s income tax return for the taxable year
in which the triggering event occurs.

(ii) Interest charge. The interest charge imposed
under this section may be appropriately reduced if the elector demonstrates,
to the satisfaction of the Commissioner, that the net interest owed would
have been less than that provided in paragraph (h)(1)(ii) of this section
if the elector had filed an amended return for the taxable year in which the
loss was incurred, and for any other affected taxable years up to and including
the taxable year of recapture, treating the dual consolidated loss as a loss
subject to the restrictions of §1.1503(d)-2(b) (and therefore subject
to the limitations under §1.1503(d)-3(c)(3)). In the case of a separate
unit, the prior sentence is applied as if the separate unit were a separate
domestic corporation that filed a consolidated return with its unaffiliated
domestic owner. An elector utilizing this rebuttal rule must prepare a computation
demonstrating the reduction in the net interest owed as a result of treating
the dual consolidated loss as a loss subject to the restrictions of §1.1503(d)-2(b)
(and therefore subject to the limitations under §1.1503(d)-3(c)(3)).
The computation must be labeled Reduction of Interest Charge at the top of
the page and must indicate that it is submitted under the provisions of paragraph
(h)(2)(ii) of this section. The computation must be signed under penalties
of perjury by the person who signs the elector’s tax return, and must
be attached to, and filed by the due date (including extensions) of, the elector’s
income tax return for the taxable year in which the triggering event occurs.
See §1.1503(d)-5(c) Examples 51 and 52.

(3) Rules regarding subsequent electors—(i) In
general. The rules of this paragraph (h)(3) apply when, subsequent
to an event described in paragraph (e)(1) of this section with respect to
which the requirements of paragraph (f)(2)(i) of this section were met (excepted
event), a triggering event under paragraph (e) of this section occurs, and
no exception applies to such triggering event under paragraph (f) of this
section (subsequent triggering event).

(ii) Original elector and prior subsequent electors not subject
to recapture or interest charge—(A) Except to the extent
provided in paragraph (h)(3) of this section, neither the original elector
nor any prior subsequent elector shall be subject to the rules of paragraph
(h) of this section with respect to dual consolidated losses subject to the
original domestic use agreement.

(B) In the case of a dual consolidated loss with respect to which multiple
excepted events have occurred, only the subsequent elector that owns the dual
resident corporation or separate unit at the time of the subsequent triggering
event shall be subject to the recapture rules of paragraph (h) of this section.
For purposes of paragraph (h) of this section, the term prior subsequent
elector refers to all other subsequent electors.

(iii) Recapture tax amount and required statement—(A) In
general. If a subsequent triggering event occurs, the subsequent
elector must prepare a statement that computes the recapture tax amount, as
provided under paragraph (h)(3)(iii)(B) of this section, with respect to the
dual consolidated loss subject to the new domestic use agreement. This statement
must be attached to, and filed by the due date (including extensions) of,
the subsequent elector’s income tax return for the taxable year in which
the subsequent triggering event occurs. The statement must be signed under
penalties of perjury by the person who signs the return. The statement must
be labeled Statement Identifying Secondary Liability at the top and, in addition
to the calculation of the recapture tax amount, must include the following
items, in paragraphs labeled to correspond with the items set forth in paragraphs
(h)(3)(iii)(A)(1) through (3) of
this section:

(1) A statement that the document is submitted
under the provisions of §1.1503(d)-4(h)(3)(iii);

(2) A statement identifying the amount of the dual
consolidated losses at issue and the taxable year in which they were used;

(3) The name, address, and tax identification number
of the original elector and all prior subsequent electors.

(1) The income tax liability of the subsequent
elector for the taxable year of the subsequent triggering event; over

(2) The income tax liability of the subsequent
elector for the taxable year of the subsequent triggering event, computed
by excluding the amount of recapture and related interest charge with respect
to the dual consolidated losses that are recaptured as a result of the subsequent
triggering event, as provided under paragraphs (h)(1) and (h)(2) of this section.

(iv) Tax assessment and collection procedures—(A) In
general—(1) Subsequent elector.
An assessment identifying an income tax liability of the subsequent elector
is considered an assessment of the recapture tax amount where the recapture
tax amount is part of the income tax liability being assessed and the recapture
tax amount is reflected in a statement attached to the subsequent elector’s
income tax return as provided under paragraph (h)(3)(iii) of this section.

(2) Original elector and prior subsequent
electors. The assessment of the recapture tax amount as set forth
in paragraph (h)(3)(iv)(A)(1) of this section shall be considered as having
been properly assessed as an income tax liability of the original elector
and of each prior subsequent elector, if any. The date of such assessment
shall be the date the income tax liability of the subsequent elector was properly
assessed. The Commissioner may collect all or a portion of such recapture
tax amount from the original elector and/or the prior subsequent electors
under the circumstances set forth in paragraph (h)(3)(iv)(B) of this section.

(B) Collection from original elector and prior subsequent
electors; joint and several liability. If the subsequent elector
does not pay in full any of the income tax liability that includes a recapture
tax amount, the Commissioner may collect that portion of the unpaid balance
of such income tax liability attributable to the recapture tax amount in full
or in part from the original elector and/or from any prior subsequent elector,
provided that the following conditions are satisfied with respect to such
elector—

(1) The Commissioner properly has assessed the
recapture tax amount pursuant to paragraph (h)(3)(iv)(A)(1)
of this section;

(2) The Commissioner has issued a notice and demand
for payment of the recapture tax amount to the subsequent elector in accordance
with §301.6303-1 of this chapter;

(3) The subsequent elector has failed to pay all
of the recapture tax amount by the date specified in such notice and demand;
and

(4) The Commissioner has issued a notice and demand
for payment of the unpaid portion of the recapture tax amount to the original
elector, or prior subsequent elector (as the case may be), in accordance with
§301.6303-1 of this chapter. The liability imposed under this paragraph
(h)(3)(iv)(B) on the original elector and each prior subsequent elector shall
be joint and several.

(C) Allocation of partial payments of tax. If
the subsequent elector’s income tax liability for a taxable period includes
a recapture tax amount, and if such income tax liability is satisfied in part
by payment, credit, or offset, such payment, credit or offset shall be allocated
first to that portion of the income tax liability that is not attributable
to the recapture tax amount, and then to that portion of the income tax liability
that is attributable to the recapture tax amount.

(D) Refund. If the Commissioner makes a refund
of any income tax liability that includes a recapture tax amount, the Commissioner
shall allocate and pay the refund to each elector who paid a portion of such
income tax liability as follows:

(1) The Commissioner shall first determine the
total amount of recapture tax paid by and/or collected from the original elector
and from any prior subsequent elector(s). The Commissioner shall then allocate
and pay such refund to the original elector and prior subsequent elector(s),
with each such elector receiving an amount of such refund on a pro
rata basis, not to exceed the amount of recapture tax paid by and/or
collected from such elector.

(2) The Commissioner shall pay any balance of such
refund, if any, to the subsequent elector.

(v) Definition of income tax liability. Solely
for purposes of paragraph (h)(3) of this section, the term income
tax liability means the income tax liability imposed on a domestic
corporation under Title 26 of the United States Code for a taxable year, including
additions to tax, additional amounts, penalties, and any interest charge related
to such income tax liability.

(vi) Example. See §1.1503(d)-5(c) Example
49.

(4) Computation of taxable income in year of recapture—(i) Presumptive
rule. Except to the extent provided in paragraph (h)(4)(ii) of
this section, for purposes of computing the taxable income for the year of
recapture, no current, carryover or carryback losses of the dual resident
corporation or separate unit, of other members of the consolidated group,
or of the domestic owner that are not attributable to the separate unit, may
offset and absorb the recapture amount.

(ii) Rebuttal of presumptive rule. The recapture
amount included in gross income may be offset and absorbed by that portion
of the elector’s (consolidated or separate) net operating loss carryover
that is attributable to the dual consolidated loss being recaptured, if the
elector demonstrates, to the satisfaction of the Commissioner, the amount
of such portion of the carryover. An elector utilizing this rebuttal rule
must prepare a computation demonstrating the amount of net operating loss
carryover that, under this paragraph (h)(4)(ii) of this section, may absorb
the recapture amount included in gross income. Such computation must be signed
under penalties of perjury and attached to and filed by the due date (including
extensions) of, the income tax return for the taxable year in which the triggering
event occurs.

(5) Character and source of recapture income. The
amount recaptured under paragraph (h) of this section shall be treated as
ordinary income. Except as provided in the prior sentence, such income shall
be treated, as applicable, as income from the same source, having the same
character, and falling within the same separate category, for all purposes
of the Internal Revenue Code, including sections 856(c)(2) and (3), 904(d),
and 907, to which the items of deduction or loss composing the dual consolidated
loss were allocated and apportioned, as provided under sections 861(b), 862(b),
863(a), 864(e), 865 and the regulations thereunder. See §1.1503(d)-5(c) Example
50.

(6) Reconstituted net operating loss. Commencing
in the taxable year immediately following the year in which the dual consolidated
loss is recaptured, the dual resident corporation or separate unit (but only
if such separate unit is owned, directly or indirectly, by a domestic corporation)
shall be treated as having a net operating loss in an amount equal to the
amount actually recaptured under paragraph (h) of this section. This reconstituted
net operating loss shall be subject to the restrictions of §1.1503(d)-2(b)
(and therefore, the restrictions of §1.1503(d)-3(c)(3)), without regard
to the exceptions contained in paragraphs (b) through (d) of this section.
The net operating loss shall be available only for carryover, under section
172(b), to taxable years following the taxable year of recapture. For purposes
of determining the remaining carryover period, the loss shall be treated as
if it had been recognized in the taxable year in which the dual consolidated
loss that is the basis of the recapture amount was incurred. See §1.1503(d)-5(c) Example
52.

(i) Termination of domestic use agreement and annual certifications—(1) Rebuttal
of triggering event. If, pursuant to paragraph (e)(2) of this section,
an elector is able to rebut the presumption of a triggering event described
in paragraphs (e)(1)(ii) through (ix) of this section, including complying
with the related reporting requirements, then the domestic use agreement filed
with respect to any dual consolidated losses that would have been recaptured
as a result of the event, but for the rebuttal, shall terminate and have no
further effect. See §1.1503(d)-5(c) Example 43.

(2) Exception to triggering event. If an event
described in paragraph (e)(1) of this section is not a triggering event as
a result of the application of paragraph (f)(2)(i) or (ii) of this section,
then the domestic use agreement filed with respect to any dual consolidated
losses that would have been recaptured as a result of the event, but for the
application of paragraph (f)(2)(i) or (f)(2)(ii) of this section, shall terminate
and have no further effect. See §1.1503(d)-5(c) Examples 46 and 49.

(3) Recapture of dual consolidated loss. If a dual
consolidated loss is recaptured pursuant to paragraph (h) of this section,
then the domestic use agreement filed with respect to such recaptured dual
consolidated loss shall terminate and have no further effect. See §1.1503(d)-5(c) Examples
49 through 52.

(4) Termination of ability for foreign use—(i) In
general. A domestic use agreement filed with respect to a dual
consolidated loss shall terminate and have no further effect as of the end
of a taxable year if the elector—

(A) Demonstrates, to the satisfaction of the Commissioner, that as of
the end of such taxable year no foreign use of the dual consolidated loss
can occur in any year by any means; and

(B) Prepares a statement described in paragraph (i)(4)(ii) of this section
that is attached to, and filed by the due date (including extensions) of,
its U.S. income tax return for such taxable year.

(ii) Statement. The statement described in this
paragraph (i)(4)(ii) must be signed under penalties of perjury by the person
who signs the return. The statement must be labeled Termination of Ability
for Foreign Use at the top of the page and must include the following items,
in paragraphs labeled to correspond with the following:

(A) A statement that the document is submitted under the provisions
of §1.1503(d)-4(i)(4).

(B) The name, address, tax identification number, and place and date
of incorporation of the dual resident corporation, and the country or countries
that tax the dual resident corporation on its worldwide income or on a residence
basis, or, in the case of a separate unit, identification of the separate
unit, including the name under which it conducts business, its principal activity,
and the country in which its principal place of business is located.

(C) A statement of the amount of the dual consolidated loss at issue
and the year in which such dual consolidated loss was incurred.

(D) An analysis, in reasonable detail and specificity, supported with
official or certified English translations of the relevant provisions of foreign
law, of the treatment of the losses and deductions composing the dual consolidated
loss under the laws of the foreign jurisdiction and the reasons supporting
the conclusion that no foreign use of the dual consolidated loss can occur
in any year by any means.

§1.1503(d)-5 Examples.

(a) In general. This section provides examples
that illustrate the application of §§1.1503(d)-1 through 1.1503(d)-4.
This section also provides facts that are presumed for such examples.

(b) Presumed facts for examples. For purposes of
the examples in this section, unless otherwise indicated, the following facts
are presumed:

(1) Each entity has only a single class of equity outstanding, all of
which is held by a single owner.

(2) P, a domestic corporation and the common parent of the P consolidated
group, owns S, a domestic corporation and a member of the P consolidated group.

(3) DRCX, a domestic corporation, is subject
to Country X tax on its worldwide income or on a residence basis, and is a
dual resident corporation.

(4) DE1X and DE2X are
both Country X entities, subject to Country X tax on their worldwide income
or on a residence basis, and disregarded as entities separate from their owners
for U.S. tax purposes. DE3Y is a Country Y entity,
subject to Country Y tax on its worldwide income or on a residence basis,
and disregarded as an entity separate from its owner for U.S. tax purposes.
The interests in DE1X, DE2X,
and DE3Y constitute hybrid entity separate units.

(5) FBX is a foreign branch, as defined in §1.367(a)-6T(g),
and is a Country X foreign branch separate unit.

(6) Neither the assets nor the activities of an entity constitutes a
foreign branch separate unit.

(7) FSX is a Country X entity that is subject
to Country X tax on its worldwide income or on a residence basis and is classified
as a foreign corporation for U.S. tax purposes.

(8) The applicable foreign jurisdiction has a consolidation regime that—

(i) Includes as members of a consolidated group any commonly controlled
branches and permanent establishments in such jurisdiction, and entities that
are subject to tax in such jurisdiction on their worldwide income or on a
residence basis; and

(ii) Allows the losses of members of consolidated groups to offset income
of other members.

(9) There is no mirror legislation, within the meaning of §1.1503(d)-1(b)(14)(v),
in the applicable foreign jurisdiction.

(10) There is no elective agreement described in §1.1503(d)-4(b)
between the United States and the applicable foreign jurisdiction.

(11) If a domestic use election, within the meaning of §1.1503(d)-4(d),
is made, all the necessary filings related to such election are properly completed
on a timely basis.

(12) If there is a triggering event requiring recapture of a dual consolidated
loss, the amount of recapture is not reduced pursuant to §1.1503(d)-4(h)(2).

(c) Examples. The following examples illustrate
the application of §§1.1503(d)-1 through 1.1503(d)-4:

(ii) Result. Pursuant to §1.1503(d)-1(b)(4)(ii),
the interest in DE1X, FBX, and
P’s share of the Country X branch owned by PRS, which is owned by P
indirectly through its interest in PRS, are combined and treated as one separate
unit owned by P. P’s interest in DE3Y, however,
is another separate unit because it is subject to tax in Country Y, rather
than Country X. S’s interest in DE2X also is
another separate unit because it is owned by S, a different domestic corporation.

Example 2. Domestic use limitation—foreign branch separate
unit. (i) Facts. P conducts operations in
Country X that constitute a permanent establishment under the Country X income
tax laws. In Year 1, P’s Country X permanent establishment has a loss,
as determined under §1.1503(d)-3(b)(2).

(ii) Result. Under §1.1503(d)-1(b)(4)(i) and
§1.367(a)-6T(g)(1), P’s Country X permanent establishment constitutes
a foreign branch separate unit. Therefore, the Year 1 loss of the foreign
branch separate unit constitutes a dual consolidated loss pursuant to §1.1503(d)-1(b)(5)(ii).
The dual consolidated loss rules apply even though there is no affiliate
of the foreign branch separate unit in Country X because it is still possible
that all or a portion of the dual consolidated loss can be put to a foreign
use. For example, there may be a foreign use with respect to an affiliate
acquired in a year subsequent to the year in which the dual consolidated loss
was generated. Accordingly, unless an exception under §1.1503(d)-4 applies
(such as a domestic use election), the Year 1 dual consolidated loss of P’s
Country X permanent establishment is subject to the domestic use limitation
rule of §1.1503(d)-2(b). As a result, the Year 1 dual consolidated loss
cannot offset income of P that is not from its Country X foreign branch separate
unit, or income from any other domestic affiliate of such foreign branch separate
unit.

Example 3. Domestic use limitation—no foreign consolidation
regime. (i) Facts. The facts are the same
as in Example 2, except that Country X does not have
a consolidation regime that includes as members of consolidated groups Country
X branches or permanent establishments.

(ii) Result. The result is the same as Example
2. The dual consolidated loss rules apply even in the absence of
a consolidation regime in the foreign country because it is possible that
all or a portion of a dual consolidated loss can be put to a foreign use by
other means, such as through an acquisition or similar transaction.

Example 4. Domestic use limitation—foreign branch separate
unit owned through a partnership. (i) Facts.
P and S organize a partnership, PRSX, under the laws
of Country X. PRSX is treated as a partnership for
both U.S. and Country X income tax purposes. PRSX owns
FBX. PRSX earns U.S. source
income that is unconnected with its FBX branch operations
and such income, therefore, is not subject to tax by Country X.

(ii) Result. Under §1.1503(d)-1(b)(4)(i),
P’s and S’s shares of FBX owned indirectly
through their interests in PRSX are foreign branch
separate units. Unless an exception under §1.1503(d)-4 applies, any dual
consolidated loss incurred by FBX cannot offset income
of P or S (other than income attributable to FBX),
including their distributive share of the U.S. source income earned through
their interests in PRSX, or income of any other domestic
affiliates of FBX.

Example 5. Domestic use limitation—interest in hybrid
entity partnership and indirectly owned foreign branch separate unit.
(i) Facts. HPSX is a Country X
entity that is subject to Country X tax on its worldwide income. HPSX is
classified as a partnership for U.S. tax purposes. P, S, and FX,
an unrelated Country X corporation, are the sole partners of HPSX.
For U.S. tax purposes, P, S, and FX each has an equal
interest in each item of HPSX’s profit or loss.
HPSX conduct operations in Country Y that, if carried
on by a U.S. person, would constitute a foreign branch within the meaning
of §1.367(a)-6T(g).

(ii) Result. Under §1.1503(d)-1(b)(4)(i),
the partnership interests in HPSX held by P and S are
hybrid entity separate units. In addition, P’s and S’s share
of the Country Y branch owned indirectly through their interests in HPSX are
foreign branch separate units. Unless an exception under §1.1503(d)-4
applies, dual consolidated losses attributable to P’s and S’s
interests in HPSX can only be used to offset income
attributable to their respective interests in HPSX (other
than income of HPSX’s Country Y foreign branch
separate unit). Similarly, dual consolidated losses of P’s and S’s
interests in the Country Y branch of HPSX can only
be used to offset income attributable to their respective interests in the
Country Y branch.

Example 6. Foreign use—general rule. (i) Facts.
P owns DE1X. DE1X owns FSX.
In Year 1, DE1X incurs a $100x net operating loss
for both U.S. and Country X tax purposes. The $100x Year 1 loss of DE1X is
attributable to P’s interest in DE1X and is a
dual consolidated loss. FSX earns $200x of income
in Year 1 for Country X tax purposes. DE1X and FSX file
a Country X consolidated tax return. For Country X purposes, the Year 1 $100x
loss of DE1X is used to offset $100x of Year 1 income
generated by FSX.

(ii) Result. DE1X’s
$100x loss offsets FSX’s income under the laws
of Country X. In addition, under U.S. tax principles, such income is an item
of FSX, a foreign corporation. As a result, under
§1.1503(d)-1(b)(14)(i), there has been a foreign use of the Year 1 dual
consolidated loss attributable to P’s interest in DE1X.
Therefore, P cannot make a domestic use election with respect to the Year
1 dual consolidated loss of DE1X as provided under
§1.1503(d)-4(d)(3)(i), and such loss will be subject to the domestic
use limitation rule of §1.1503(d)-2(b). The result would be the same
even if FSX, under Country X laws, had no income against
which the dual consolidated loss of DE1X could be offset
(unless FSX’s ability to use the loss under Country
X laws requires an election, and no such election is made).

Example 7. Foreign use—foreign reverse hybrid structure.
(i) Facts. P owns DE1X. DE1X owns
99% and S owns 1% of FRHX, a Country X partnership
that elected to be treated as a corporation for U.S. tax purposes. FRHX conducts
an active business in Country X. The 99% interest in FRHX is
the only asset owned by DE1X. DE1X’s
sole item of income, gain, deduction, or loss in Year 1 for purposes of calculating
a dual consolidated loss attributable to P’s interest in DE1X is
interest expense incurred on a loan from an unrelated party. DE1X’s
Year 1 interest expense constitutes a dual consolidated loss. In Year 1, for
Country X income tax purposes, DE1X took into account
its distributive share of income generated by FRHX and
offset such income with its interest expense.

(ii) Result. In year 1, the dual consolidated loss
attributable to P’s interest in DE1X, offsets
income recognized in Country X and under U.S. tax principles the income is
considered to be income of FRHX, a foreign corporation.
Accordingly, pursuant to §1.1503(d)-1(b)(14)(i), there is a foreign use
of the dual consolidated loss. Therefore, P cannot make a domestic use election
with respect to DE1X’s Year 1 dual consolidated
loss, as provided under §1.1503(d)-4(d)(3)(i), and such loss will be
subject to the domestic use limitation rule of §1.1503(d)-2(b).

Example 8. Foreign use—inapplicability of no dilution
exception to foreign reverse hybrid structure. (i) Facts.
The facts are the same as in Example 7, except as follows.
Instead of owning DE1X, P owns 75% of HPSX,
a Country X entity subject to Country X tax on its worldwide income. FX,
an unrelated foreign corporation, owns the remaining 25% of HPSX.
HPSX is classified as a partnership for U.S. income
tax purposes. HPSX owns 99% and S owns 1% of FRHX.
HPSX incurs the Year 1 interest expense and P’s
interest in HPSX, therefore, has a dual consolidated
loss in Year 1.

(ii) Result. In year 1, the dual consolidated loss
attributable to P’s interest in HPSX offsets
income recognized under Country X law and under U.S. tax principles the income
is considered to be income of FRHX, a foreign corporation.
Accordingly, pursuant to §1.1503(d)-1(b)(14)(i), there is a foreign
use of the dual consolidated loss. In addition, the exception to foreign
use under §1.1503(d)-1(b)(14)(iii)(C)(1)(i)
does not apply because the foreign use is not solely the result of the dual
consolidated loss being made available under Country X laws to offset an item
of income or gain recognized under Country X laws that is considered, under
U.S. tax principles, to be an item of FX. Instead,
the income that is offset is, under U.S. tax principles, income of FRHX,
a foreign corporation. Therefore, P cannot make a domestic use election with
respect to the Year 1 dual consolidated loss attributable to its interest
in HPSX, and such loss will be subject to the domestic
use limitation rule of §1.1503(d)-2(b).

Example 9. Foreign use—dual resident corporation with
hybrid entity joint venture. (i) Facts. P
owns DRCX, a member of the P consolidated group. DRCX owns
80% of HPSX, a Country X entity that is subject to
Country X tax on its worldwide income. HPSX is classified
as a partnership for U.S. tax purposes. FX, an unrelated
foreign corporation, owns the remaining 20% of HPSX.
In Year 1, DRCX generates a $100x net operating loss.
Also in Year 1, HPSX generates $100x of income for
Country X tax purposes. DRCX and HPSX file
a consolidated tax return for Country X tax purposes, and HPSX offsets
its $100x of income with the $100x loss generated by DRCX.

(ii) Result. The $100x Year 1 net operating loss
incurred by DRCX is a dual consolidated loss. In addition,
HPSX is a hybrid entity and DRCX’s
interest in HPSX is a hybrid entity separate unit;
however, there is no dual consolidated loss attributable to such separate
unit in Year 1. DRCX’s Year 1 dual consolidated
loss offsets $100x of income for Country X purposes, and $20x of such amount
is (under U.S. tax principles) income of FX, which
owns an interest in HPSX that is not a separate unit.
As a result, pursuant to §1.1503(d)-1(b)(14)(i), there is a foreign
use of the Year 1 dual consolidated loss of DRCX, and
P cannot make a domestic use election with respect to such loss pursuant to
§1.1503(d)-4(d)(3)(i). Therefore, such loss will be subject to the domestic
use limitation rule of §1.1503(d)-2(b).

Example 10. Foreign use—foreign parent corporation.
(i) Facts. F1 and F2, nonresident alien individuals,
each own 50% of FPX, a Country X entity that is subject
to Country X tax on its worldwide income. FPX is classified
as a corporation for U.S. tax purposes. FPX owns DRCX.
DRCX is the parent of a consolidated group that includes
as a member DS, a domestic corporation. In Year 1, DRCX generates
a dual consolidated loss of $100x and, for Country X tax purposes, FPX generates
$100x of income. In Year 1, FPX elects to consolidate
with DRCX, and the $100x Year 1 loss of DRCX is
used to offset the income of FPX under the laws of
Country X. For U.S. tax purposes, the items of FPX do
not constitute items of income in Year 1.

(ii) Result. The Year 1 dual consolidated loss
of DRCX offsets the income of FPX under
the laws of Country X. Pursuant to §1.1503(d)-1(b)(14)(i), the offset
constitutes a foreign use because the items constituting such income are considered
under U.S. tax principles to be items of a foreign corporation. This is the
case even though the United States does not recognize such items as income
in Year 1. Therefore, DRCX cannot make a domestic
use election with respect to its Year 1 dual consolidated loss pursuant to
§1.1503(d)-4(d)(3)(i). As a result, such loss will be subject to the
domestic use limitation rule of §1.1503(d)-2(b).

Example 11. Foreign use—parent hybrid entity.
(i) Facts. The facts are the same as Example
10, except that FPX is classified as a partnership
for U.S. tax purposes.

(ii) Result. The dual consolidated loss of DRCX offsets
the income of FPX under the laws of Country X. Pursuant
to §1.1503(d)-1(b)(14)(i), such offset constitutes a foreign use because
the items constituting such income are considered under U.S. tax principles
to be items of F1 and F2, the owners of interests in FPX (a
hybrid entity), that are not separate units. Therefore, DRCX cannot
make a domestic use election with respect to its Year 1 dual consolidated
loss pursuant to §1.1503(d)-4(d)(3)(i). As a result, such loss will
be subject to the domestic use limitation rule of §1.1503(d)-2(b). The
result would be the same if F1 and F2 owned their interests in FPX indirectly
through another partnership.

Example 12. No foreign use—absence of foreign loss allocation
rules. (i) Facts. P owns DE1X and
DRCX. DRCX is a member of the
P consolidated group and owns FSX. In Year 1, DRCX incurs
a $200x net operating loss for both U.S. and Country X tax purposes, while
DE1X recognizes $200x of income in Year 1 under the
tax laws of each country. The $200x loss of DRCX is
a dual consolidated loss. FSX also earns $200x of
income in Year 1 for Country X tax purposes. DRCX,
DE1X, and FSX file a Country
X consolidated tax return. However, Country X has no applicable rules for
determining which income is offset by DRCX’s
Year 1 $200x loss.

(ii) Result. Under §1.1503(d)-1(b)(14)(iii)(B),
DRCX’s $200x loss shall be treated as having
been made available to offset DE1X’s $200x of
income. DE1X is not, under U.S. tax principles, a
foreign corporation, and there is no interest in DE1X that
is not a separate unit. As a result, DRCX’s
loss being made available to offset the income of DE1X is
not considered a foreign use of such loss. Therefore, P can make a domestic
use election with respect to DRCX’s Year 1 dual
consolidated loss.

Example 13. No foreign use—absence of foreign loss usage
ordering rules. (i) Facts. (A) P owns DRCX,
a member of the P consolidated group. DRCX owns FSX.
Under the Country X consolidation regime, a consolidated group may elect
in any given year to use all or a portion of the losses of one consolidated
group member to offset income of other consolidated group members. If no
such election is made in a year in which losses are generated by a consolidated
member, such losses carry forward and are available, at the election of the
consolidated group, to offset income of consolidated group members in subsequent
tax years. Country X law does not provide ordering rules for determining
when a loss from a particular tax year is used because, under Country X law,
losses never expire. Similarly, Country X law does not provide ordering rules
for determining when a particular type of loss (for example, capital or ordinary)
is used. The United States and Country X recognize the same items of income,
gain, deduction and loss in each year. In addition, neither DRCX nor
FSX has items of income or loss for the taxable year
other than those stated below.

(B) In Year 1, DRCX incurs a capital loss of
$80x which, under §1.1503(d)-3(b)(1), is not a dual consolidated loss.
DRCX also incurs a net operating loss of $80x in Year
1. FSX generates $60x of capital gain in Year 1 which,
for Country X purposes, can be offset by capital losses and net operating
losses. DRCX elects to use $60x of its total Year
1 loss of $160x to offset the $60x of capital gain generated by FSX in
Year 1; the remaining $100x of Year 1 loss carries forward. In Year 2, DRCX incurs
a net operating loss of $100x, while FSX incurs a net
operating loss of $50x. DRCX’s $100x loss is
a dual consolidated loss. Because DRCX does not elect
under the laws of Country X to use all or a portion of its Year 2 net operating
loss of $100x to offset the income of other members of the Country X consolidated
group, P is permitted to make (and in fact does make) a domestic use election
with respect to the Year 2 dual consolidated loss of DRCX.
In Year 3, DRCX has a net operating loss of $10x and
FSX generates $60x of capital gains. Country X law
permits, upon an election, FSX’s $60x of capital
gain generated in Year 3 to be offset by losses (including carryover losses
from prior years) of other group members. Accordingly, in Year 3, DRCX elects
to use $60x of its accumulated losses to offset the $60x of Year 3 capital
gain generated by FSX.

(ii) Result. (A) DRCX’s
$80x Year 1 net operating loss is a dual consolidated loss. Under the ordering
rules of §1.1503(d)-1(b)(14)(iv)(C), a pro rata amount
of DRCX’s Year 1 net operating loss ($30x) and
capital loss ($30x) is considered to be used to offset FSX’s
Year 1 $60x capital gain. As a result, P will not be able to make a domestic
use election with respect to DRCX’s Year 1 $80x
dual consolidated loss.

(B) DRCX’s $10x Year 3 net operating loss
is also a dual consolidated loss. Under the ordering rules of §1.1503(d)-1(b)(14)(iv)(A),
such loss is considered to be used to offset $10x of FSX’s
Year 3 $60x capital gain. Consequently, P will not be able to make a domestic
use election with respect to such loss. Under the ordering rules of §1.1503(d)-1(b)(14)(iv)(B),
$50x of loss carryover from Year 1 will be considered to offset the remaining
$50x of Year 3 income because the income is deemed to have been offset by
losses from the earliest taxable year from which a loss can be carried forward
or back for foreign law purposes. Thus, none of DRCX’s
$100x Year 2 net operating loss will be deemed to offset FSX’s
remaining $50x of Year 3 income. As a result, such offset will not constitute
a foreign use of DRCX’s Year 2 dual consolidated
loss.

Example 14. No foreign use—no dilution of an interest
in a separate unit. (i) Facts. (A) P owns
50% of HPSX, a Country X entity subject to Country
X tax on its worldwide income. FX, an unrelated foreign
corporation, owns the remaining 50% of HPSX. HPSX is
classified as a partnership for U.S. income tax purposes.

(B) The United States and Country X recognize the same items of income,
gain, deduction and loss in Years 1 and 2. In Year 1, HPSX incurs
a loss of $100x. Under §1.1503(d)-1(b)(4)(i)(B), P’s interest
in HPSX is a separate unit and P’s interest in
HPSX has a dual consolidated loss of $50x in Year 1.
P makes a domestic use election with respect to such dual consolidated loss.
In Year 2, HPSX generates $50x of income. Under Country
X income tax laws, the $100x of Year 1 loss incurred by HPSX is
carried forward and offsets the $50x of income generated by HPSX in
Year 2; the remaining $50x of loss is carried forward and is available to
offset income generated by HPSX in subsequent years.
P and FX maintain their 50% ownership interests in
HPSX throughout Years 1 and 2.

(ii) Result. In Year 2, under the laws of Country
X, the $100x of Year 1 loss, which includes the $50x dual consolidated loss
attributable to P’s interest in HPSX, is made
available to offset income of HPSX. Such income would
be attributable to P’s interest in HPSX, which
is a separate unit. Such income would also be income of FX,
an owner of an interest in HPSX, which is not a separate
unit. Under §1.1503(d)-1(b)(14)(iii)(B), because Country X does not
have applicable rules for determining which Year 2 income of HPSX is
offset by the $100x loss carried forward from year 1, the $50x dual consolidated
loss is deemed to first have been made available to offset the $25x of income
attributable to P’s interest in HPSX. However,
because only $25x of income is attributable to P’s interest in HPSX,
a portion of the remaining $25x of the dual consolidated loss is made available
(under U.S. tax principles) to offset income of FX.
As a result, a portion of the $50x dual consolidated loss is made available
to offset income of the owner of an interest in a hybrid entity that is not
a separate unit and, under the general rule of §1.1503(d)-1(b)(14)(i),
there would be a foreign use of P’s $50x Year 1 dual consolidated loss
(there would also be a foreign use in this case because FX is
a foreign corporation). However, pursuant to the exception to foreign use
under §1.1503(d)-1(b)(14)(iii)(C)(1)(i), there is
no foreign use of the Year 1 dual consolidated loss in Year 2. In addition,
the exceptions under §1.1503(d)-1(b)(14)(iii)(C)(2)
do not apply because P’s interest in HPSX as
of the end of Year 1 has not been reduced, and the portion of the $50x dual
consolidated loss was made available for a foreign use in Year 2 solely as
a result of FX’s ownership in HPSX and
by the offsetting of income attributable to HPSX, the
partnership in which FX holds an interest. Therefore,
there is no foreign use of the Year 1 dual consolidated loss in Year 2. The
result would be the same if FX owned its interest in
HPSX indirectly through a partnership.

Example 15. Foreign use—dilution of an interest in
a separate unit. (i) Facts. The facts are
the same as Example 14, except that at the beginning
of Year 2, FX contributes cash to HPSX in
exchange for additional equity of HPSX. As a result
of the contribution, FX’s interest in HPSX increases
from 50% to 60%, and P’s interest in HPSX decreases
from 50% to 40%.

(ii) Result. At the beginning of Year 2, P’s
interest in HPSX has been reduced as a result of a
person other than a domestic corporation acquiring an interest in HPSX.
Accordingly, pursuant to §1.1503(d)-1(b)(14)(iii)(C)(2)(i),
the exception to foreign use provided under §1.1503(d)-1(b)(14)(iii)(C)(1)(i)
does not apply. Therefore, in Year 2 there is a foreign use of the $50x Year
1 dual consolidated loss attributable to P’s interest in HPSX.
Such foreign use constitutes a triggering event and the $50x Year 1 dual
consolidated loss is recaptured.

Example 16. No foreign use—dilution by a domestic corporation. (i) Facts.
The facts are the same as Example 14, except that at
the beginning of Year 2, instead of FX contributing
cash to HPSX, S purchases 20% of P’s interest
in HPSX. As a result of the purchase, P’s interest
in HPSX decreases from 50% to 40%.

(ii) Result. At the beginning of Year 2, P’s
interest in HPSX has been reduced as a result of a
person acquiring an interest in HPSX. Accordingly,
§1.1503(d)-1(b)(14)(iii)(C)(1)(i)
generally does not apply, and there would be a foreign use of the $50x Year
1 dual consolidated loss attributable to P’s interest in HPSX.
However, if P demonstrates, to the satisfaction of the Commissioner, that
S is a domestic corporation in a statement attached to, and filed by the due
date (including extensions) of P’s U.S. income tax return for the taxable
year in which the ownership interest of P was reduced, the exception to foreign
use under §1.1503-1(b)(14)(iii)(C)(1)(i)
will apply. In such a case, there will be no foreign use of the $50x Year
1 dual consolidated loss attributable to P’s interest in HPSX.
The result would be the same if S were unrelated to P, or if S acquired its
interest in HPSX through the contribution of property
to HPSX in exchange for equity (rather than as a purchase
of a portion of P’s interest).

Example 17. Foreign use—foreign consolidation.
(i) Facts. (A) P and FX, an unrelated
Country X corporation, organize HPSY. P owns 20% of
HPSY and FX owns 80% of HPSY.
HPSY is classified as a partnership for U.S. income
tax purposes and is a Country Y entity subject to Country Y tax on its worldwide
income. HPSY conducts operations in Country X that,
if carried on by a U.S. person, would constitute a foreign branch within the
meaning of §1.367(a)-6T(g).

(B) In Year 1, the Country X branch of HPSY has
a loss of $100x as determined under §1.1503(d)-3(b)(2). Under §1.1503(d)-1(b)(4)(i),
P’s interest in HPSY is a separate unit, and
P’s indirect interest in a portion of the Country X branch of HPSY is
also a separate unit. As a result, P has a dual consolidated loss of $20x
in Year 1 attributable to its interest in the Country X branch owned indirectly
through HPSY. HPSY conducts
no other activities in Year 1 and has no other items of income, gain, deduction
or loss. Accordingly, there is no dual consolidated loss attributable to
P’s interest in HPSY. Under Country X income
tax laws, FX elects to consolidate with the Country
X branch of HPSY. As a result, the $100x Year 1 loss
of the Country X branch of HPSY is available to offset
the income of FX under the laws of Country X through
consolidation.

(ii) Result. Pursuant to §1.1503(d)-1(b)(14)(iii)(C)(1)(ii),
P’s Year 1 $20x dual consolidated loss attributable to its indirect
ownership of the Country X branch of HPSY would not
generally be considered to be made available, under the laws of Country X,
to reduce or offset an item of income or gain that is considered under U.S.
tax principles to be income of FX. However, FX elected
to consolidate with the Country X branch under Country X law such that the
$20x dual consolidated loss attributable to P’s interest in such separate
unit is available to offset income under the laws of Country X as described
in §1.1503(d)-1(b)(14)(iii)(C)(2)(ii).
As a result, the exception under §1.1503(d)-1(b)(14)(iii)(C)(1)(ii)
shall not apply and there is a foreign use of the $20x Year 1 dual consolidated
loss attributable to P’s interest in the Country X branch of HPSY.

Example 18. No foreign use—no election to consolidate
under foreign law. (i) Facts. The facts are
the same as in Example 17, except that FX does
not elect under Country X law to consolidate with the Country X branch of
HPSY.

(ii) Result. Because FX does
not elect to consolidate under foreign law, P’s dual consolidated loss
of $20x is not made available to offset FX’s
income, other than as a result of FX’s ownership
of HPSY. Accordingly, because there has been no dilution
of P’s interest in the Country X branch of HPSY,
there has been no foreign use of P’s $20x Year 1 dual consolidated loss
pursuant §1.1503(d)-1(b)(14)(iii)(C)(1)(ii).

Example 19. No foreign use—combination rule.
(i) Facts. (A) P and FX, an unrelated
foreign corporation, form PRSX. P and FX each
own 50 percent of PRSX throughout Years 1 and 2.
PRSX is treated as a partnership for both U.S. and
Country X income tax purposes. PRSX owns DEY.
DEY is a Country Y entity subject to Country Y tax
on its worldwide income and disregarded as an entity separate from its owner
for U.S. tax purposes. PRSX does not have any items
of income, gain, deduction, or loss from sources other than DEY.
P also owns FBY, a Country Y foreign branch separate
unit. Pursuant to Country Y law, the losses of DEY are
available to offset the income of FBY, and vice versa.
Under §1.1503(d)-1(b)(4)(i), P’s interest in DEY,
owned indirectly through PRSX, is a hybrid entity separate
unit. In addition, under §1.1503(d)-1(b)(4)(ii), FBY and
P’s indirect interest in DEY are treated as a
combined separate unit.

(B) The United States and Country Y recognize the same items of income,
gain, deduction and loss in Years 1 and 2. In year 1, DEY incurs
a $100x loss and FBY incurs a $200x loss. Under §1.1503(d)-3(b)(vii)(B),
the dual consolidated loss attributable to P’s combined separate unit
is $250x ($50x loss attributable to P’s indirect interest in DEY plus
$200x loss of FBY). In Year 2, DEY generates
no income or loss.

(ii) Result. Under Country Y law, the $100x of
Year 1 loss incurred by DEY is carried forward and
is available to offset income of DEY in Year 2. As
a result, a portion of such loss will be available to offset income of DEY that
is attributable to P’s interest in DEY owned
indirectly through PRSX. A portion of such loss will
also be available to offset income of DEY that is attributable
to FX’s indirect ownership of DEY.
Accordingly, under §1.1503(d)-1(b)(14)(i), there would be a foreign
use of a portion of P’s $250x Year 1 dual consolidated loss because
it is available to offset an item of income of the owner of an interest in
a hybrid entity, which is not a separate unit (there would also be a foreign
use in this case because FX is a foreign corporation).
However, under §1.1503(d)-1(b)(14)(iii)(C)(1)(ii)
and (iii), and because there has been no dilution of
P’s interest in DEY (and no consolidation of
DEY), no foreign use occurs as a result of the carryforward.

Example 20. Mirror legislation rule—dual resident corporation.
(i) Facts. P owns DRCX, a member
of the P consolidated group. DRCX owns FSX.
In Year 1, DRCX generates a $100x net operating loss
that is a dual consolidated loss. To prevent corporations like DRCX from
offsetting losses both against income of affiliates in Country X and against
income of foreign affiliates under the tax laws of another country, Country
X mirror legislation prevents a corporation that is subject to the income
tax of another country on its worldwide income or on a residence basis from
using the Country X form of consolidation. Accordingly, the Country X mirror
legislation prevents the loss of DRCX from being made
available to offset income of FSX.

(ii) Result. Under §1.1503(d)-1(b)(14)(v),
because the losses of DRCX are subject to Country X’s
mirror legislation, there shall, other than for purposes of the consistency
rule under §1.1503(d)-4(d)(2), be a deemed foreign use of DRCX’s
Year 1 dual consolidated loss. Therefore, P will not be able to make a domestic
use election with respect to DRCX’s Year 1 dual
consolidated loss pursuant to §1.1503(d)-4(d)(3)(i).

Example 21. Mirror legislation rule—standalone foreign
branch separate unit. (i) Facts. P owns FBX.
In Year 1, FBX incurs a dual consolidated loss of
$100x. Under Country X tax laws, FBX also generates
a loss. Country X enacted mirror legislation to prevent Country X branches
of nonresident corporations from offsetting losses both against income of
Country X affiliates and against other income of its owner (or foreign affiliate
thereof) under the tax laws of another country. The Country X mirror legislation
prevents a Country X branch of a nonresident corporation from offsetting its
losses against the income of Country X affiliates if such losses may be deductible
against income (other than income of the Country X branch) under the laws
of another country.

(ii) Result. Under §1.1503(d)-1(b)(14)(v),
because the losses of FBX are subject to Country X’s
mirror legislation, there shall, other than for purposes of the consistency
rule under §1.1503(d)-4(d)(2), be a deemed foreign use of FBX’s
Year 1 dual consolidated loss. This is the result even though P has no Country
X affiliates. Therefore, P cannot make a domestic use election with respect
to the Year 1 dual consolidated loss of FBX pursuant
to §1.1503(d)-4(d)(3)(i).

Example 22. Mirror legislation rule—absence of election
to file consolidated return under local law. (i) Facts.
The facts are the same as in Example 21, except that
P also owns FSX and no election is made under Country
X law to consolidate FBX and FSX.

(ii) Result. The result is the same as Example
21, even though FBX has a Country X affiliate
and no election is made under Country X law to consolidate FBX and
FSX.

Example 23. Mirror legislation rule—inapplicability
to particular dual resident corporation or separate unit. (i) Facts.
The facts are the same as in Example 21, except as follows.
Rather than conducting operations in Country X through a foreign branch,
P owns DE1X. In Year 1, DE1X incurs
a loss of $100x and also generates a loss for Country X tax purposes. The
$100x Year 1 loss of DE1X is a dual consolidated loss
attributable to P’s interest in DE1X.

(ii) Result. The Country X mirror legislation only
applies to Country X branches owned by non-resident corporations and therefore
does not apply to losses generated by DE1X. Thus,
if DE1X had a Country X affiliate, it would be permitted
under the laws of Country X to use its loss to offset income of such affiliate,
notwithstanding the Country X mirror legislation. As a result, the mirror
legislation rule under §1.1503(d)-1(b)(14)(v) does not apply with respect
to the Year 1 dual consolidated loss of P’s interest in DE1X.
Therefore, a domestic use election can be made with respect to such loss
(provided the conditions for such an election are otherwise satisfied).

Example 24. Dual consolidated loss limitation after section
381 transaction—disposition of assets and subsequent liquidation of
dual resident corporation. (i) Facts. P owns
DRCX, a member of the P consolidated group. In Year
1, DRCX incurs a dual consolidated loss and P does
not make a domestic use election with respect to such loss. Under §1.1503(d)-2(b),
DRCX’s Year 1 dual consolidated loss may not
be used to offset the income of P or S (or the income of any other domestic
affiliate of DRCX) on the group’s consolidated
U.S. income tax return. At the beginning of Year 2, DRCX sells
all of its assets and discontinues its business operations. DRCX is
then liquidated into P pursuant to section 332.

Example 25. Dual consolidated loss limitation after section
381 transaction—liquidation of dual resident corporation.
(i) Facts. The facts are the same as in Example
24, except as follows. DRCX’s activities
constitute a foreign branch within the meaning of §1.367(a)-6T(g) and
therefore are a foreign branch separate unit. In addition, DRCX’s
foreign branch separate unit incurs the Year 1 dual consolidated loss, rather
than DRCX itself. Finally, DRCX does
not sell its assets and, following the liquidation of DRCX,
P continues to operate DRCX’s business as a foreign
branch separate unit.

(ii) Result. Pursuant to §1.1503(d)-2(c)(2)(iii),
DRCX’s Year 1 loss carryover is available to
offset P’s income generated by the foreign branch separate unit previously
owned by DRCX (and now owned by P), subject to the
limitations of §1.1503(d)-3(c) applied as if the separate unit of P generated
the dual consolidated loss.

Example 26. Tainted income. (i) Facts.
P owns 100% of DRCZ, a domestic corporation that
is included as a member of the P consolidated group. The P consolidated group
uses the calendar year as its taxable year. During Year 1, DRCZ was
managed and controlled in Country Z and therefore was subject to tax as a
resident of Country Z and was a dual resident corporation. In Year 1, DRCZ generated
a dual consolidated loss of $200x, and P did not make a domestic use election
with respect to such loss. As a result, such loss is subject to the domestic
use limitation rule of §1.1503(d)-2(b). At the end of Year 1, DRCZ moved
its management and control from Country Z to the United States and therefore
ceased being a dual resident corporation. At the beginning of Year 2, P transferred
asset A, a non-depreciable asset, to DRCZ in exchange
for common stock in a transaction that qualified for nonrecognition under
section 351. At the time of the transfer, P’s tax basis in asset A
equaled $50x and the fair market value of asset A equaled $100x. The tax
basis of asset A in the hands of DRCZ immediately after
the transfer equaled $50x pursuant to section 362. Asset A did not constitute
replacement property acquired in the ordinary course of business. DRCZ did
not generate income or gain during Years 2, 3 or 4. On June 30, Year 5, DRCZ sold
asset A to a third party for $100x, its fair market value at the time of the
sale, and recognized $50x of income on such sale. In addition to the $50x
income generated on the sale of asset A, DRCZ generated
$100x of operating income in Year 5. At the end of Year 5, the fair market
value of all the assets of DRCZ was $400x.

(ii) Result. DRCZ ceased
being a dual resident corporation at the end of Year 1. Therefore, its Year
1 dual consolidated loss cannot be offset by tainted income. Asset A is a
tainted asset because it was acquired in a nonrecognition transaction after
DRCZ ceased being a dual resident corporation (and
was not replacement property acquired in the ordinary course of business).
As a result, the $50x of income recognized by DRCZ on
the disposition of asset A is tainted income and cannot be offset by the Year
1 dual consolidated loss of DRCZ. In addition, absent
evidence establishing the actual amount of tainted income, $25x of the $100x
Year 5 operating income of DRCZ (($100x/$400x) x $100x)
also is treated as tainted income and cannot be offset by the Year 1 dual
consolidated loss of DRCZ under §1.1503(d)-2(d)(2)(ii).
Therefore, $75x of the $150x Year 5 income of DRCZ constitutes
tainted income and may not be offset by the Year 1 dual consolidated loss
of DRCZ; however, the remaining $75x of Year 5 income
of DRCZ may be offset by such dual consolidated loss.

Example 27. Treatment of disregarded item. (i) Facts.
P owns DE1X. In Year 1, DE1X incurs
interest expense attributable to a loan made from P to DE1X.
DE1X has no other items of income, gain, deduction,
or loss in Year 1. Because DE1X is disregarded as
an entity separate from its owner, however, the interest expense is disregarded
for federal tax purposes.

(ii) Result. Even though DE1X is
treated as a separate domestic corporation for purposes of determining the
amount of dual consolidated loss pursuant to §1.1503(d)-3 (b)(2)(i),
such treatment does not cause the interest expense incurred on the loan from
P to DE1X that is disregarded for federal tax purposes
to be regarded for purposes of calculating the Year 1 dual consolidated loss,
if any, of DE1X. Therefore, P’s interest in
DE1X does not have a dual consolidated loss in Year
1.

Example 28. Hybrid entity books and records. (i) Facts.
P owns DE1X. In Year 1, P incurs interest expense
attributable to a loan from a third party. The third party loan and related
interest expense are properly recorded on the books and records of P (and
not on the books and records of DE1X).

(ii) Result. The interest expense on P’s
loan from the third party is not properly recorded on the books and records
of DE1X. No portion of the interest expense on such
loan is attributable to DE1X pursuant to §1.1503(d)-3(b)(2)(iii)
and (iv). Therefore, no portion of the interest expense is taken into account
for purposes of calculating the Year 1 dual consolidated loss, if any, attributable
to P’s interest in DE1X pursuant to §1.1503(d)-3(b)(2).

Example 29. Dividend income attributable to a separate unit.
(i) Facts. P owns DE1X. DE1X owns
DE3Y. DE3Y owns CFC, a controlled
foreign corporation. P’s interest in DE1X would
otherwise have a dual consolidated loss of $75x (without regard to Year 1
dividend income or section 78 gross-up received from CFC) in Year 1. In Year
1, CFC distributes $50x to DE3Y that is taxable as
a dividend. DE3Y distributes the same amount to DE1X.
P computes foreign taxes deemed paid on the dividend under section 902 of
$25x and includes that amount in gross income under section 78 as a dividend.

(ii) Result. The $75x of dividend income ($50x
distribution plus $25x section 78 gross-up) is properly recorded on the books
and records of DE3Y, as adjusted to conform to U.S.
tax principles. Accordingly, for purposes of determining whether the interest
in DE3Y has a dual consolidated loss, the $75x dividend
income from CFC is an item of income attributable to DE3Y,
a disregarded entity, and therefore is an item attributable to the interest
in DE3Y. The distribution of $50x from DE3Y to
DE1X is generally not regarded for tax purposes and
therefore does not give rise to an item that is taken into account for purposes
of calculating a dual consolidated loss. As a result, the dual consolidated
loss of $75x attributable to P’s interest in DE1X in
Year 1 is not reduced by the amount of dividend income attributable to the
interest in DE3Y.

Example 30. Items attributable to a combined separate unit.
(i) Facts. P owns DE1X. DE1X owns
a 50% interest in PRSZ, a Country Z entity that is
classified as a partnership both for Country Z tax purposes and for U.S. tax
purposes. FZ, a Country Z corporation unrelated to
P, owns the remaining 50% interest in PRSZ. PRSZ conducts
operations in Country X that, if owned by a U.S. person, would constitute
a foreign branch as defined in §1.367(a)-6T(g). Therefore, P’s
share of the Country X branch owned by PRSZ constitutes
a foreign branch separate unit. PRSZ also owns assets
that do not constitute a part of its Country X branch.

(ii) Result. (A) Pursuant to §1.1503(d)-1(b)(4)(ii),
P’s interest in DE1X, and P’s indirect
ownership of a portion of the Country X branch of PRSZ,
are combined and treated as one Country X separate unit. Pursuant to §1.1503(d)-3(b)(2)(vii)(B)(1),
for purposes of determining P’s items of income, gain, deduction and
loss taken into account by its combined separate unit, the items of P are
first attributed to each separate unit that compose the combined Country X
separate unit.

(B) Pursuant to §1.1503(d)-3(b)(2)(ii)(A), the principles of section
864(c)(2), as modified, apply for purposes of determining P’s items
of income, gain, deduction (other than interest expense) and loss that are
taken into account in determining the taxable income or loss of P’s
indirect interest in the Country X foreign branch owned by PRSZ.
For purposes of determining interest expense taken into account in determining
the taxable income or loss of P’s indirect interest in the Country X
foreign branch owned by PRSZ, the principles of §1.882-5,
subject to §1.1503(d)-3(b)(2)(ii)(B). For purposes of applying the principles
of section 864(c) and §1.882-5, P is treated as a foreign corporation,
the Country X branch of PRSZ is treated as a trade
or business within the United States, and the assets of P (other than those
of FBX) are treated as assets that are not U.S. assets.
In addition, pursuant to §1.1503(d)-3(b)(2)(vii)(A)(1),
only the items of DE1X and PRSZ are
taken into account for purposes of this determination.

(C) For purposes of determining the items of income, gain, deduction
and loss that are attributable to DE1X and, therefore,
attributable to P’s interest in DE1X, only those
items that are properly reflected on the books and records of DE1X,
as adjusted to conform to U.S. tax principles, are taken into account. For
this purpose, DE1X’s distributive share of the
items of income, gain, deduction and loss that are properly reflected on the
books and records of PRSZ, as adjusted to conform to
U.S. tax principles, are treated as being reflected on the books and records
of DE1X, except to the extent such items are taken
into account by the Country X branch of PRSZ, as provided
above.

(D) Pursuant to §1.1503(d)-3(b)(2)(vii)(B)(2),
the combined Country X separate unit of P calculates its dual consolidated
loss by taking into account all the items of income, gain deduction and loss
that were separately taken into account by P’s interest in DE1X and
the Country X branch of PRSZ owned indirectly by P.

Example 31. Sale of branch by domestic owner. (i) Facts.
P owns FBX. FBX has a $100x
dual consolidated loss in Year 1. P makes a domestic use election with respect
to such dual consolidated loss. In Year 2, P sells FBX and
recognizes $75x of gain as a result of such sale. The sale is a triggering
event of the Year 1 dual consolidated loss under §1.1503(d)-4(e)(1).

(ii) Result. Pursuant to §1.1503(d)-3(b)(2)(vii)(C),
the gain on the sale of FBX is attributable to FBX for
purposes of calculating the Year 2 dual consolidated loss (if any) of FBX,
and for purposes of determining FBX’s Year 2
taxable income for purposes of rebutting the amount of the Year 1 dual consolidated
loss to be recaptured pursuant to §1.1503(d)-4(h)(2)(i). Assuming FBX has
no other items of income, gain, deduction and loss in Year 2, only $25x of
the Year 1 dual consolidated loss must be recaptured.

Example 32. Sale of separate unit by another separate unit.
(i) Facts. P owns DE1X. DE1X owns
DE3Y. DE1X sells its interest
in DE3Y at the end of Year 1 to an unrelated third
party. The sale resulted in an ordinary loss of $30x. Without regard to
the sale of DE3Y, no items of income, gain, deduction
or loss are attributable to the interest of DE3Y in
Year 1.

(ii) Result. Pursuant to §1.1503(d)-3(b)(2)(vii)(C),
the $30x loss recognized on the sale is attributable to the interest in DE3Y,
and not the interest in DE1X. In addition, the loss
attributable to the sale creates a Year 1 dual consolidated loss attributable
to the interest in DE3Y. Pursuant to §1.1503(d)-4(d)(3)(i),
P cannot make a domestic use election with respect to the Year 1 dual consolidated
loss attributable to the interest in DE3Y because the
sale of the interest in DE3Y is described in §1.1503(d)-4(e)(1).
As a result, although the Year 1 dual consolidated loss would otherwise be
subject to the domestic use limitation rule of §1.1503(d)-2(b), it is
eliminated pursuant to §1.1503(d)-2(c)(1)(ii).

Example 33. Gain and loss on sale of tiered separate units.
(i) Facts. P owns DE1X. DE1X owns
DE3Y. P sells its interest in DE1X to
an unrelated third party. As a result of this sale, P recognizes $25x of
net gain, consisting of $75 of income and $50 of loss. If DE1X sold
its assets in a taxable transaction immediately before the sale of P’s
interest in DE1X, DE1X would
have recognized $75x of income. In addition, if DE3Y had
sold its assets in a taxable transaction immediately before the sale of P’s
interest in DE1X, DE3Y would
have recognized a $50x loss.

(ii) Result. Pursuant to §1.1503(d)-3(b)(2)(vii)(C),
the $75x of income and $50x of loss must be allocated to the interests of
DE1X and DE3Y based on the amount
of gain or loss that would be recognized if such entities sold their assets
in a taxable exchange for an amount equal to their fair market value immediately
before P sold its interest in DE1X. Therefore, $75x
of gain and $50x of loss recognized by P on the sale of its interest DE1X are
attributable to the interests in DE1X and DE3Y,
respectively. As a result, such items will be taken into account in determining
whether an interest in either entity has a dual consolidated loss in the year
of the sale and for purposes of rebutting the amount of recapture of any dual
consolidated loss (for which a domestic use election was made) of DE1X from
a prior year, if any, pursuant to §1.1503(d)-4(h)(2)(i).

Example 34. Gain on sale of tiered separate units.
(i) Facts. P owns 75% of HPSX,
a Country X entity subject to Country X tax on its worldwide income. FX,
an unrelated foreign corporation, owns the remaining 25% of HPSX.
HPSX is classified as a partnership for U.S. income
tax purposes. HPSX owns operations in Country Y that,
if owned by a U.S. person, would constitute a foreign branch within the meaning
of §1.367(a)-6T(g). HPSX also owns assets that
do not constitute a part of its Country Y branch. P’s indirect interest
in the Country Y branch owned by HPSX, and P’s
interest in HPSX, are each separate units. P sells
its interest in HPSX and recognizes a gain of $150x
on such sale. Immediately prior to P’s sale of its interest in HPSX,
P’s indirect interest in HPSX’s Country
Y branch had a net built-in gain of $200x, and P’s pro rata portion
of HPSX’s other assets had a net built-in gain
of $100x.

(ii) Result. Pursuant to §1.1503(d)-3(b)(2)(vii)(C),
$100x of the total $150x of gain recognized ($200x/$300x x $150x) is taken
into account for purposes of determining the taxable income of P’s indirect
interest in its share of the Country Y branch owned by HPSX.
Thus, such amount will be taken into account in determining whether it has
a dual consolidated loss in the year of the sale and for purposes of rebutting
the amount of dual consolidated loss recapture, if any, pursuant to §1.1503(d)-4(h)(2)(i).
Similarly, $50x of such gain ($100x/$300x x $150x) is attributable to P’s
interest in HPSX and will be taken into account in
determining whether it has a dual consolidated loss in the year of sale, and
for purposes of rebutting the amount of recapture, if any, pursuant to §1.1503(d)-4(h)(2)(i).

Example 35. Effect on domestic affiliate. (i) Facts.
(A) P owns DE1X. In Years 1 and 2, the items of
income, gain, deduction, and loss that are attributable to P’s interest
in DE1X for purposes of determining whether such interest
has a dual consolidated loss for each year, pursuant to §1.1503(d)-3(b)(2),
are as follows:

Item

Year 1

Year 2

Sales income

$100x

$160x

Salary expense

($75x)

($75x)

Research and experimental expense

($50x)

($50x)

Interest expense

($25x)

($25x)

Income/(dual consolidated loss)

($50x)

($10x)

(B) P does not make a domestic use election with respect to DE1X’s
Year 1 dual consolidated loss. Pursuant to §§1.1503(d)-2(b) and
1.1503(d)-3(c)(2), DE1X’s Year 1 dual consolidated
loss of $50x is treated as a loss incurred by a separate corporation and is
subject to the limitations under §1.1503(d)-3(c)(3).

(ii) Result. (A) P must compute its taxable income
for Year 1 without taking into account the $50x dual consolidated loss attributable
to P’s interest in DE1X. Such amount consists
of a pro rata portion of the expenses that were taken
into account by DE1X in calculating its Year 1 dual
consolidated loss. Thus, the items of the dual consolidated loss that are
not taken into account by P in computing its taxable income are as follows:
$25x of salary expense ($75x/$150x x $50x); $16.67x of research and experimental
expense ($50x/$150x x $50x); and $8.33x of interest expense ($25x/$150x x
$50x). The remaining amounts of each of these items, together with the $100x
of sales income, are taken into account by P in computing its taxable income
for Year 1 as follows: $50x of salary expense ($75x - $25x); $33.33x of research
and experimental expense ($50x - $16.67x); and $16.67x of interest expense
($25x - $8.33x).

(B) Subject to the limitations provided under §1.1503(d)-3(c)(3),
the $50x dual consolidated loss generated by DE1X in
Year 1 is carried forward and is available to offset the $10x of income generated
by DE1X in Year 2. A pro rata portion
of each item of deduction or loss included in such dual consolidated loss
is considered to be used to offset the $10x of income, as follows: $5x of
salary expense ($25x/$50x x $10x); $3.33x of research and experimental expense
($16.67x/$50x x $10x); and $1.67x of interest expense ($8.33x/$50x x $10x).
The remaining amount of each item shall continue to be subject to the limitations
under §1.1503(d)-3(c)(3).

Example 36. Basis adjustment rule—year of dual consolidated
loss. (i) Facts. (A) In addition to S, P
owns S1, a domestic corporation. S owns DRCX and DRCX,
in turn, owns FSX. S, S1 and DRCX are
each members of the P consolidated group. W and Y are unrelated corporations
that are not members of the P consolidated group.

(B) At the beginning of Year 1, P has a basis of $1,000x in the stock
of S. S has a $500x basis in the stock of DRCX.

(C) In Year 1, DRCX incurs interest expense in
the amount of $100x. In addition, DRCX sells a noncapital
asset, u, in which it has a basis of $10x, to S1 for $50x. DRCX also
sells a noncapital asset, v, in which it has a basis of $200x, to S1 for $100x.
The sales of u and v are intercompany transactions described in §1.1502-13.
DRCX also sells a capital asset, z, in which it has
a basis of $180x, to Y for $90x. In Year 1, S1 earns $200x of separate taxable
income, calculated in accordance with §1.1502-12, as well as $90x of
capital gain from a sale of an asset to W. P and S have no items of income,
gain, deduction or loss for Year 1.

(D) In Year 1, DRCX has a dual consolidated loss
of $100x (attributable to its interest expense). The sale of non-capital
assets u and v to S1, which are intercompany transactions, are not taken into
account in calculating DRCX’s dual consolidated
loss. Pursuant to §1.1503(d)-3(b)(1), DRCX’s
$90x capital loss also is not included in the computation of the dual consolidated
loss. Instead, DRCX’s capital loss is included
in the computation of the consolidated group’s capital gain net income
under §1.1502-22(c) and is used to offset S1’s $90x capital gain.

(E) For Country X tax purposes, DRCX’s
$100x loss is available to offset the income of FSX,
a foreign corporation, and therefore constitutes a foreign use. As a result,
DRCX is not eligible to make a domestic use election
pursuant to §1.1503(d)-4(d), and the $100x Year 1 dual consolidated loss
of DRCX is subject to the domestic use limitation rule
of §1.1503(d)-2(b).

(ii) Result. (A) Because DRCX has
a dual consolidated loss for the year, the consolidated taxable income of
the consolidated group is calculated without regard to DRCX’s
items of loss or deduction taken into account in computing its dual consolidated
loss (that is, the $100x of interest expense). Therefore, the consolidated
taxable income of the consolidated group is $200x (the sum of $200x of separate
taxable income earned by S1, plus $90x of capital gain earned by S1, minus
$90x of capital loss incurred by DRCX). The $40x gain
of DRCX upon the sale of item u to S1, and the $100x
loss of DRCX upon the sale of item v to S1, are deferred
pursuant to §1.1502-13(c).

(B) Pursuant to §1.1503(d)-3(d)(1)(i), S must make a negative adjustment
under §1.1502-32(b)(2) to its basis in the stock of DRCX for
the $100x dual consolidated loss incurred by DRCX.
In addition, S must make a negative adjustment under §1.1502-32(b)(2)
in the basis of the DRCX stock for DRCX’s
$90x capital loss because the loss has been absorbed by the consolidated group.
Thus, S must make a $190x net negative adjustment to its basis in the stock
of DRCX, reducing its basis from $500x to $310x. As
provided in §1.1502-32(a)(3)(iii), the adjustments in the DRCX stock
made by S are taken into account in determining P’s basis in its S stock.
Since S has no items of income, gain, deduction or loss for the taxable year,
P must only make a negative adjustment to its basis in the stock of S to account
for the tiering-up of adjustments for the taxable year pursuant to §1.1502-32(a)(3)(iii).
Thus, P must make a $190x net negative adjustment to its basis in S stock,
reducing its basis from $1,000x to $810x.

Example 37. Basis adjustment rule—subsequent income
of dual resident corporation. (i) Facts.
(A) The facts are the same as in Example 36, except as
follows. In Year 2, S1 sells items u and v to W for no gain or loss. The
disposition of items u and v outside of the P consolidated group causes the
intercompany gain and loss of DRCX attributable to
u and v to be taken into account pursuant to §1.1502-13(c). DRCX also
incurs $100x of interest expense in Year 2. In addition, DRCX sells
a noncapital asset, r, in which it has a basis of $100x, to Y for $300x.
P and S have no items of income, loss, or deduction for Year 2.

(B) DRCX has $40x of separate taxable income
in Year 2, computed as follows:

Interest Expense

($100x)

Sale of Item v to S1

($100x)

Sale of Item u to S1

$40x

Sale of Item r to Y

$200x

Net Income/(Loss)

$40x

(C) Since DRCX does not have a dual consolidated
loss for Year 2, the group’s consolidated taxable income for the year
is calculated in accordance with the general rule of §1.1502-11, and
not in accordance with §1.1503(d)-3(c). In addition, DRCX is
the only member of the consolidated group that has any income or loss for
the taxable year. Thus, the consolidated taxable income of the group, computed
without regard to DRCX’s dual consolidated loss
carryover, is $40x.

(ii) Result. (A) As provided under §1.1503(d)-3(c),
the portion of the $100x dual consolidated loss arising in Year 1 that is
included in the group’s consolidated net operating loss deduction for
Year 2 is $40x. Thus, the P group has no consolidated taxable income for the
year.

(B) Pursuant to §1.1503(d)-3(d)(1)(ii), S does not make a negative
adjustment to its basis in DRCX stock for the $40x
of Year 1 dual consolidated loss that is absorbed in Year 2. However, pursuant
to §1.1502-32(b), S does make a $40x net positive adjustment to its basis
in DRCX stock, increasing its basis from $310x to $350x.
In addition, as provided in §1.1502-32(a)(3)(iii), the adjustments in
the DRCX stock made by S are taken into account in
determining P’s basis in its S stock. Since S has no other items of
income, gain, deduction or loss for the taxable year, P must only make a positive
adjustment to its basis in the stock of S for to account for the tiering-up
of adjustments for the taxable year pursuant to §1.1502-32(a)(3)(iii).
Thus, P must make a $40x net positive adjustment to its basis in S stock,
increasing its basis from $810x to $850x.

Example 38. Exception to domestic use limitation—no
possibility of foreign use because items are not deducted or capitalized under
foreign law. (i) Facts. P owns DE1X.
In Year 1, the sole item of income, gain, deduction or loss attributable to
P’s interest in DE1X as provided under §1.1503(d)-3(b)(2)
is $100x of interest expense. For Country X tax purposes, the $100x interest
expense attributable to P’s interest in DE1X in
Year 1 is treated as a repayment of principal and therefore cannot be deducted
(at any time) or capitalized.

(ii) Result. The $100x of interest expense attributable
to P’s interest in DE1X constitutes a dual consolidated
loss. However, because the sole item constituting the dual consolidated loss
cannot be deducted or capitalized for Country X tax purposes, P can demonstrate
that there can be no foreign use of the dual consolidated loss at any time.
As a result, pursuant to §1.1503(d)-4(c)(1), if P prepares a statement
described in §1.1503(d)-4(c)(2) and attaches it to its timely filed tax
return, the Year 1 dual consolidated loss of DE1X will
not be subject to the domestic use limitation rule of §1.1503(d)-2(b).

Example 39. No exception to domestic use limitation—inability
to demonstrate no possibility of foreign use because items are deferred under
foreign law. (i) Facts. P owns DE1X.
In Year 1, the sole items of income, gain, deduction or loss attributable
to P’s interest in DE1X as provided under §1.1503(d)-3(b)(2)
are $75x of sales income and $100x of depreciation expense. For Country X
tax purposes, DE1X also generates $75x of sales income
in Year 1, but the $100x of depreciation expense is not deductible in Year
1. Instead, for Country X tax purposes the $100x of depreciation expense
is deductible in Year 2. P does not make a domestic use election with respect
to the Year 1 dual consolidated loss attributable to P’s interest in
DE1X.

(ii) Result. The Year 1 $25x net loss of DE1X constitutes
a dual consolidated loss attributable to P’s interest in DE1X.
In addition, even though DE1X has positive income
in Year 1 for Country X tax purposes, P cannot demonstrate that there is no
possibility of foreign use of its dual consolidated loss as provided under
§1.1503(d)-4(c)(1)(i). P cannot make such a demonstration because the
depreciation expense, an item composing the Year 1 dual consolidated loss,
is deductible (in a later year) for Country X tax purposes and, therefore,
may be available to offset or reduce income for Country X purposes that would
constitute a foreign use. For example, if DE1X elected
to be classified as a corporation pursuant to §301.7701-3(c) of this
chapter effective as of the end of Year 1, and the deferred depreciation expense
were available for Country X tax purposes to offset Year 2 income of DE1X,
an entity treated as a foreign corporation in Year 2 for U.S. tax purposes,
there would be a foreign use. P could, however, make a domestic use election
pursuant to §1.1503(d)-4(d) with respect to the Year 1 dual consolidated
loss.

Example 40. No exception to domestic use limitation—inability
to demonstrate no possibility of foreign use because items are deferred and
not deducted or capitalized under foreign law. (i) Facts.
P owns DE1X. In Year 1, the sole items of income,
gain, deduction or loss attributable to P’s interest in DE1X as
provided in §1.1503(d)-3(b)(2) are $75x of sales income, $100x of interest
expense and $25x of depreciation expense. For Country X tax purposes, DE1X generates
$75x of sales income in Year 1, but the $100x interest expense is treated
as a repayment of principal and therefore cannot be deducted (at any time)
or capitalized. In addition, for Country X tax purposes the $25x of depreciation
expense is not deductible in Year 1, but is deductible in Year 2.

(ii) Result. The Year 1 $50x net loss of DE1X constitutes
a dual consolidated loss attributable to P’s interest in DE1X.
Even though the $100x interest expense, a nondeductible and noncapital item
for Country X tax purposes, exceeds the $50x Year 1 dual consolidated loss
of DE1X, P cannot demonstrate that there is no possibility
of foreign use of the dual consolidated loss as provided under §1.1503(d)-4(c)(1)(i).
P cannot make such a demonstration because the $25x depreciation expense,
an item of deduction or loss composing the Year 1 dual consolidated loss,
is deductible under Country X law (in Year 2) and, therefore, may be available
to offset or reduce income for Country X purposes that would constitute a
foreign use. P could, however, make a domestic use election pursuant to §1.1503(d)-4(d)
with respect to the Year 1 dual consolidated loss.

Example 41. Consistency rule—deemed foreign use.
(i) Facts. P owns DRCX, a member
of the P consolidated group, FBX, and FSX.
In Year 1, DRCX incurs a dual consolidated loss, which
is used to offset the income of FSX under the Country
X form of consolidation. FBX also incurs a dual consolidated
loss in Year 1. However, P elects not to use the FBX loss
on a Country X consolidated return to offset the income of Country X affiliates.

(ii) Result. The use of DRCX’s
dual consolidated loss to offset the income of FSX for
Country X purposes constitutes a foreign use. Pursuant to §1.1503(d)-4(d)(2),
this foreign use results in a foreign use of the dual consolidated loss of
FBX. Therefore, the dual consolidated loss attributable
to FBX is subject to the domestic use limitation rule
of §1.1503(d)-2(b), and P cannot make a domestic use election with respect
to such loss.

Example 42. Consistency rule—no foreign use permitted.
(i) Facts. The facts are the same as in Example
41, except that the income tax laws of Country X do not permit
Country X branches of foreign corporations to file consolidated income tax
returns with Country X affiliates.

(ii) Result. The consistency rule does not apply
with respect to the dual consolidated loss of FBX because
the income tax laws of Country X do not permit a foreign use for such dual
consolidated loss. Therefore, P may make a domestic use election for the dual
consolidated loss attributable to FBX.

Example 43. Triggering event rebuttal—expiration of
losses in foreign country. (i) Facts. P owns
DRCX, a member of the P consolidated group. In Year
1, DRCX incurs a dual consolidated loss of $100x.
P makes a domestic use election with respect to DRCX’s
Year 1 dual consolidated loss and such loss therefore is included in the computation
of the P group’s consolidated taxable income. DRCX has
no income or loss in Year 2 through Year 6. In Year 7, P sells the stock
of DRCX to an unrelated party. At the time of the
sale of the stock of DRCX, all of the losses and deductions
that were included in the computation of the Year 1 dual consolidated loss
of DRCX had expired for Country X purposes because
the laws of Country X only provide for a five year carryover period of such
items.

(ii) Result. The sale of DRCX to
the unrelated party generally would be a triggering event under §1.1503(d)-4(e)(1)(ii),
which would require the recapture of the Year 1 dual consolidated loss (and
an applicable interest charge). However, upon adequate documentation that
the losses and deductions have expired for Country X purposes, P can rebut
the presumption that a triggering event has occurred pursuant to §1.1503(d)-4(e)(2).
Pursuant to §1.1503(d)-4(i)(1), if the triggering event presumption
is rebutted, the domestic use agreement filed by the P consolidated group
with respect to the Year 1 dual consolidated loss of DRCX is
terminated and has no further effect (absent a rebuttal, the domestic use
agreement would terminate pursuant to §1.1503(d)-4(i)(3)).

Example 44. Inability to rebut triggering event—tax
basis carryover transaction. (i) Facts. (A)
P owns DE1X. DE1X’s sole
asset is A, which it acquired at the beginning of Year 1 for $100x. DE1X does
not have any liabilities. For U.S. tax purposes, DE1X’s
tax basis in A at the beginning of Year 1 is $100x and DE1X’s
sole item of income, gain, deduction and loss for Year 1 is a $20x depreciation
deduction attributable to A. As a result, DE1X’s
Year 1 $20x depreciation deduction constitutes a dual consolidated loss attributable
to P’s interest in DE1X. P makes a domestic use
election with respect to DE1X’s Year 1 dual consolidated
loss.

(B) For Country X tax purposes, DE1X has a $100x
tax basis in A at the beginning of Year 1, but A is not a depreciable asset.
As a result, DE1X does not have any items of income,
gain, deduction or loss in Year 1 for Country X tax purposes.

(C) At the beginning of Year 2, P sells its interest in DE1X to
F, an unrelated foreign person, for $80x. P’s disposition of its interest
in DE1X constitutes a presumptive triggering event
under §1.1503(d)-4(e)(1) requiring the recapture of the $20x dual consolidated
loss (plus the applicable interest charge). For Country X tax purposes, DE1X retains
its tax basis of $100x in A following the sale.

(ii) Result. The Year 1 dual consolidated loss
is a result of the $20x depreciation deduction attributable to A. Although
no item of loss or deduction was recognized by DE1X by
the time of the sale for Country X tax purposes, the deduction composing the
dual consolidated loss was retained by DE1X after the
sale in the form of tax basis in A. As a result, a portion of the dual consolidated
loss may offset income for Country X purposes in a manner that would constitute
a foreign use. For example, if DE1X were to dispose
of A, the amount of gain recognized by DE1X would be
reduced and, therefore, an item composing the dual consolidated loss would
reduce foreign income of an owner of an interest in a hybrid entity that is
not a separate unit. Thus, P cannot demonstrate pursuant to §1.1503(d)-4(e)(2)
that there can be no foreign use of the Year 1 dual consolidated loss following
the triggering event and must recapture the Year 1 dual consolidated loss.
Pursuant to §1.1503(d)-4(i)(3), the domestic use agreement filed by
the P consolidated group with respect to the Year 1 dual consolidated of DE1X
is terminated and has no further effect.

Example 45. Ability to rebut triggering event—taxable
asset sale. (i) Facts. The facts are the
same as Example 44, except that instead of P selling
its interests in DE1X to F, DE1X sells
asset A to F for $80x. Such sale constitutes a presumptive triggering event
under §1.1503(d)-4(e)(1). For Country X tax purposes, F’s tax
basis in A is $80x.

(ii) Result. The Year 1 dual consolidated loss
attributable to P’s interest in DE1X is a result
of the $20x depreciation deduction attributable to A. For Country X tax purposes,
however, F’s tax basis in A was not determined, in whole or in part,
by reference to the basis of A in the hands of DE1X.
As a result, the deduction composing the dual consolidated loss will not
give rise to an item of deduction or loss in the form of tax basis for Country
X purposes (for example, when F disposes of A). Therefore, P may be able
to demonstrate pursuant to §1.1503(d)-4(e)(2) that there can be no foreign
use of the Year 1 dual consolidated loss and, thus, may not be required to
recapture the Year 1 dual consolidated loss. Pursuant to §1.1503(d)-4(i)(1),
if such a demonstration is made, the domestic use agreement filed by the P
consolidated group with respect to the Year 1 dual consolidated loss of DE1X is
terminated pursuant to §1.1503(d)-4(i)(1) and has no further effect (absent
a rebuttal, the domestic use agreement would terminate pursuant to §1.1503(d)-4(i)(3)).

Example 46. Termination of consolidated group not a triggering
event if acquirer files a new domestic use agreement. (i) Facts.
P owns DRCX, a member of the P consolidated group.
The P consolidated group uses the calendar year as its taxable year. In
Year 1, DRCX incurs a dual consolidated loss and P
makes a domestic use election with respect to such loss. No member of the
P consolidated group incurs a dual consolidated loss in Year 2. On December
31, Year 2, T, the parent of the T consolidated group acquires all the stock
of P, and all the members of the P group, including DRCX,
become members of a consolidated group of which T is the common parent.

(ii) Result. (A) Under §1.1503(d)-4(f)(2)(ii)(B),
the acquisition by T of the P consolidated group is not an event described
in §1.1503(d)-4(e)(1) requiring the recapture of the Year 1 dual consolidated
loss of DRCX (and the payment of an interest charge),
provided that the T consolidated group files a new domestic use agreement
described in §1.1503(d)-4(f)(2)(iii)(A). If a new domestic use agreement
is filed, then pursuant to §1.1503(d)-4(i)(2), the domestic use agreement
filed by the P consolidated group with respect to the Year 1 dual consolidated
loss of DRCX is terminated and has no further effect.

(iii) If a triggering event occurs on December 31, Year 3, the T consolidated
group must recapture the dual consolidated loss that DRCX incurred
in Year 1 (and pay an interest charge), as provided in §1.1503(d)-4(h).
Each member of the T consolidated group, including DRCX and
any former members of the P consolidated group, is severally liable for the
additional tax (and the interest charge) due upon the recapture of the dual
consolidated loss of DRCX. In addition, pursuant to
§1.1503(d)-4(i)(3), the new domestic use agreement filed by the T group
with respect to the Year 1 dual consolidated loss of DRCX is
terminated and has no further effect.

Example 47. No triggering event if consolidated group remains
in existence in connection with a reverse acquisition. (i) Facts.
S owns FBX. FBX incurs a dual
consolidated loss of $100x in Year 1 and P makes a domestic use election with
respect to such loss. At the end of Year 2, P merges into T, the common parent
of the T consolidated group, which includes U as a member. The shareholders
of P immediately before the merger, as a result of owning stock in P, own
60% of the fair market value of T’s stock immediately after the merger.

(ii) Result. The P group is treated as continuing
in existence under §1.1502-75(d)(3) with T and U being added as members
of the P group, and T taking the place of P as the common parent. The merger
of P into T does not constitute a triggering event with respect to the dual
consolidated loss in Year 1 pursuant to §1.1503(d)-4(e)(1)(ii) because
the P consolidated group, which owned FBX, continues
to exist.

Example 48. Triggering event exception—acquisition of
assets by domestic owner. (i) Facts. P owns
DE1X. In Year 1, DE1X incurs
a loss of $100x and, as a result, P’s interest in DE1X has
a Year 1 dual consolidated loss of $100x. P makes a domestic use election
with respect to the Year 1 dual consolidated loss and such loss therefore
is included in the computation of the P group’s consolidated taxable
income. In Year 3, DE1X dissolves and surrenders its
Country X corporate charter. Pursuant to its dissolution, DE1X distributes
its assets and liabilities to P and the shares of DE1X are
cancelled.

(ii) Result. The disposition of the assets of DE1X (and
the disposition of P’s interest in DE1X) as a
result of the dissolution generally would be a triggering event under §1.1503(d)-4(e)(1).
However, because the assets of DE1X are acquired by
P, its domestic owner, as a result of the dissolution, the dissolution does
not constitute a triggering event under §1.1503(d)-4(f)(1).

Example 49. Subsequent elector rules. (i) Facts.
P owns DRCX, a member of the P consolidated group.
The P consolidated group uses the calendar year as its taxable year. In
Year 1, DRCX incurs a dual consolidated loss and P
makes a domestic use election with respect to such loss. No member of the
P consolidated group incurs a dual consolidated loss in Year 2. On December
31, Year 2, T, the parent of the T consolidated group that also uses the calendar
year as its taxable year, acquires all the stock of DRCX for
cash.

(ii) Result. (A) Under §1.1503(d)-4(f)(2)(i)(A),
the acquisition by T of DRCX is not an event described
in §1.1503(d)-4(e)(1) requiring the recapture of the Year 1 dual consolidated
loss of DRCX (and the payment of an interest charge),
provided: (1) the T consolidated group files a new domestic use agreement
described in §1.1503(d)-4(f)(2)(iii)(A) with respect to the Year 1 dual
consolidated loss of DRCX; and (2) the P consolidated
group files a statement described in §1.1503(d)-4(f)(2)(iii)(B) with
respect to the Year 1 dual consolidated loss of DRCX.
If these requirements are satisfied, then pursuant to §1.1503(d)-4(i)(2)
the domestic use agreement filed by the P consolidated group with respect
to the Year 1 dual consolidated loss of DRCX is terminated
and has no further effect (if such requirements are not satisfied, the domestic
use agreement would terminate pursuant to §1.1503(d)-4(i)(3).

(B) Assume a triggering event occurs on December 31, Year 3, that requires
recapture by the T consolidated group of the dual consolidated loss that DRCX incurred
in Year 1, as well as the payment of an interest charge, as provided in §1.1503(d)-4(h).
In that case, each member of the T consolidated group, including DRCX,
is severally liable for the additional tax (and the interest charge) due upon
the recapture of the Year 1 dual consolidated loss of DRCX.
The T consolidated group must prepare a statement that computes the recapture
tax amount as provided under §1.1503(d)-4(h)(3)(iii). Pursuant to §1.1503(d)-4(h)(3)(iv)(A),
the recapture tax amount is assessed as an income tax liability of the T consolidated
group and is considered as having been properly assessed as an income tax
liability of the P consolidated group. If the T consolidated group does not
pay in full the income tax liability attributable to the recapture tax amount,
the unpaid balance of such recapture tax amount may be collected from the
P consolidated group in accordance with the provisions of §1.1503(d)-4(h)(3)(iv)(B).
Pursuant to §1.1503(d)-4(i)(3), the new domestic use agreement filed
by the T consolidated group is terminated and has no further effect.

Example 50. Character and source of recapture income.
(i) Facts. (A) P owns DE1X. In
Year 1, the items of income, gain, deduction, and loss that are attributable
to P’s interest in DE1X for purposes of determining
whether such interest has a dual consolidated loss are as follows:

Sales income

$100x

Salary expense

($75x)

Interest expense

($50x)

Dual consolidated loss

($25x)

(B) P makes a domestic use election with respect to the Year 1 dual
consolidated loss attributable to P’s interest in DE1X and,
thus, the $25x dual consolidated loss is included in the computation of P’s
taxable income.

(C) Pursuant to §1.861-8, the $75x of salary expense incurred by
DE1X is allocated and apportioned entirely to foreign
source general limitation income. Pursuant to §1.861-9T, $25x of the
$50x interest expense attributable to DE1X is allocated
and apportioned to domestic source income, $15x of such interest expense is
allocated and apportioned to foreign source general limitation income, and
the remaining $10x of such interest expense is allocated and apportioned to
foreign source passive income.

(D) During Year 2, DE1X generates $5x of income,
an amount which the $25x dual consolidated loss generated by DE1X in
Year 1 would have offset if such loss had been subject to the separate return
limitation year restrictions as provided under §1.1503(d)-3(c)(3).

(E) At the beginning of Year 3, DE1X undergoes
a triggering event within the meaning of §1.1503(d)-4(e)(1). Pursuant
to §1.1503(d)-4(h)(2)(i), P demonstrates, to the satisfaction of the
Commissioner, that the $5x generated by DE1X in Year
2 qualifies to reduce the amount that P must recapture as a result of the
triggering event.

(ii) Result. P must recapture and report as income
$20x ($25x - $5x) of DE1X’s Year 1 dual consolidated
loss, plus applicable interest, on its Year 3 tax return. Pursuant to §1.1503(d)-4(h)(5),
the recapture income is treated as ordinary income whose source and character
(including section 904 separate limitation character) is determined by reference
to the manner in which the recaptured items of expense or loss taken into
account in calculating the dual consolidated loss were allocated and apportioned.
Accordingly, P’s $20x of recapture income is characterized and sourced
as follows: $4x of domestic source income (($25x/$125x) x $20x); $14.4x of
foreign source general limitation income (($75x + $15x)/$125x) x $20x); and
$1.6x of foreign source passive income (($10x/$125x) x $20x). Pursuant to
§1.1503(d)-4(i)(3), the domestic use agreement filed by the P consolidated
group with respect to the Year 1 dual consolidated of DE1X
is terminated and has no further effect.

Example 51. Interest charge without recapture.
(i) Facts. P owns DE1X. In
Year 1, a dual consolidated loss of $100x is attributable to P’s interest
in DE1X. P makes a domestic use election with respect
to the Year 1 dual consolidated loss and uses the loss to offset the P group’s
consolidated taxable income. DE1X earns income of
$100x in Year 2. At the end of Year 2, DE1X undergoes
a triggering event within the meaning of §1.1503(d)-4(e)(1). P demonstrates,
to the satisfaction of the Commissioner, that taking into the limitation of
§1.1503(d)-3(c)(3) (modified SRLY limitation), the Year 1 $100x dual
consolidated loss would have been offset by the $100x Year 2 income.

(ii) Result. There is no recapture of the Year
1 dual consolidated loss attributable to P’s interest in DE1 because
it is reduced to zero under §1.1503(d)-4(h)(2)(i). However, P is liable
for one year of interest charge under §1.1503(d)-4(h)(1)(ii), even though
P’s recapture amount is zero. Pursuant to §1.1503(d)-4(i)(3),
the domestic use agreement filed by the P consolidated group with respect
to the Year 1 dual consolidated of DE1X is terminated
and has no further effect.

Example 52. Reduced recapture and interest charge, and reconstituted
dual consolidated loss. (i) Facts. P owns
DRCX, a member of the P consolidated group. In Year
1, DRCX incurs a dual consolidated loss of $100x and
P earns $100x. P makes a domestic use election with respect to DRCX’s
Year 1 dual consolidated loss. Therefore, the consolidated group is permitted
to offset P’s $100x of income with DRCX’s
$100x loss. In Year 2, DRCX earns $30x, which is completely
offset by a $30x net operating loss incurred by P in Year 2. In Year 3, DRCX earns
income of $25x, while P recognizes no income or loss. In addition, there is
a triggering event at the end of Year 3.

(ii) Result. (A) Under the presumptive rule of
§1.1503(d)-4(h)(1)(i), DRCX must recapture $100x.
However, the $100x recapture amount may be reduced by the amount by which
the dual consolidated loss would have offset other taxable income if it had
been subject to the limitation under §1.1503(d)-3(c)(3), upon adequate
documentation of such offset under §1.1503(d)-4(h)(2)(i).

(B) Although DRCX earned $30x of income in Year
2, there was no consolidated taxable income in such year. As a result, the
$100x of recapture income cannot be reduced by the $30x earned in Year 2,
but such amount can be carried forward to subsequent taxable years and be
used to the extent of consolidated taxable income generated in such years.
In Year 3, DRCX earns $25x of income and the P consolidated
group has $25 of consolidated taxable income in such year. As a result, the
$100x of recapture income can be reduced by the $25x. The $30x generated
in Year 2 cannot be used in Year 3 because there is insufficient consolidated
taxable income in such year.

(C) Commencing in Year 4, the $75x recapture amount ($100x - $25x) is
reconstituted and treated as a loss incurred by DRCX in
a separate return limitation year, subject to the limitation under §1.1503(d)-2(b)
(and therefore subject to the restrictions of §1.1503(d)-3(c)(3)). The
carryover period of the loss, for purposes of section 172(b), will start from
Year 1, when the dual consolidated loss was incurred. Pursuant to §1.1503(d)-4(i)(3),
the domestic use agreement filed by the P consolidated group with respect
to the Year 1 dual consolidated of DE1X is terminated
and has no further effect.

§1.1503(d)-6 Effective date.

Sections 1.1503(d)-1 through 1.1503(d)-5 shall apply to dual consolidated
losses incurred in taxable years beginning after the date that these regulations
are published as final regulations in the Federal Register.

Par. 4. In §1.6043-4T, paragraph (a)(1)(iii) is amended by removing
the language “§1.1503-2(c)(2)” and adding “§1.1503(d)-1(b)(2)”
in its place.

Mark E. Matthews, Deputy
Commissioner for Services and Enforcement.

Note

(Filed by the Office of the Federal Register on May 19, 2005, 9:47 a.m.,
and published in the issue of the Federal Register for May 24, 2005, 70 F.R.
29867)

Drafting Information

The principal author of these regulations is Kathryn T. Holman of the
Office of Associate Chief Counsel (International). However, other personnel
from the IRS and Treasury Department participated in their development.